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The  Federal  Reserve 
System 


Blackstone  Legal  Training  Lecture 


Blackstone  Institute,  Chicago 


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THE   FEDERAL   RESERVE 
SYSTEM 


BY 

HENRY  PARKER  WILLIS,  A.B.,  Ph.D. 

Formerly    Secretary,    Federal    Eeserve    Board;    Director    of    Eesearch, 
Federal  Eeserve  Board  j  Professor  of  Banking,  Columbia  University. 


One  of  a  Series  of  Lectures  Especially  Prepared 
for  the  Blackstone  Institute 


BLACKSTONE    INSTITUTE 
CHICAGO 

Copyright,   1920,   by   Blackstone   Instltate 


\<rZO  '    HENRY  PARKER  WILLIS 

After  receiving  his  degrees  of  Bachelor  of  Arts 
in  1894,  and  Doctor  of  Philosophy,  in  1897,  at  the 
University  of  Chicago,  Mr.  Willis  spent  several 
semesters  at  the  Universities  of  Leipzig  and 
Vienna. 

Upon  his  return  to  America  he  served  as  Pro- 
fessor of  Economics  and  Political  Science  at 
Washington  and  Lee  University  until  1905,  when 
he  was  appointed  Professor  of  Finance  at  George 
Washington  University,  and  in  1912  he  was  se- 
lected to  act  as  Dean  of  the  College  of  Political 
Science  in  the  same  institution.  During  the  years 
1913  and  1914  he  lectured  at  Columbia  University 
on  economic  subjects.  Mr.  Willis  had  acted  as 
expert  to  the  committee  which  presented  the  Fed- 
eral Reserve  Act,  and  was  later  chairman  of  the 
Technical  Organization  Committee  which  planned 
the  organization  of  the  new  banks,.  Upon  the 
creation  of  the  Federal  Reserve  Board  in  1914, 
Mr.  Willis  was  selected  to  act  as  Secretary.  In 
February,  1916,  he  was  also  appointed  President 
of  the  newly  authorized  Philippine  National  Bank, 
organizing  both  the  parent  office  of  the  bank  and 
its  New  York  agency. 

Mr.  Willis  has  also  acted  as  expert  for  the 
Monetary  Commission  of  1897,  the  United  States 
Immigration  Commission,  and  the  Joint  Commit- 
tee on  Rural  Credits.  During  his  long  residence 
in  Washington  he  has  served  as  Washington  corre- 
spondent for  numerous  newspapers  and  commer- 
cial journals,  including  the  New  York  Journal  of 
Commerce  and  the  Springfield  Republican.  He 
h'as  visited  Japan,  China  and  the  Philippines  as  a 
special  correspondent  for  several  newspapers  and 
is  now  editor  of  the  Journal  of  Commerce  of  New 
York. 

Among  Mr.  Willis '  published  works  are :  ' '  The 
History  of  the  Latin  Monetary  Union,"  "Reci- 
procity, "  * '  Our  Philippine  Problem, "  *  *  Principles 
and  Problems  of  Modern  Banking,"  "American 
Banking,"  "Principles  of  Accounting,"  "Life  of 
Stephen  A.  Douglas." 


t«. 


THE  FEDERAL   RESERVE 
SYSTEM 


^  By 

Henry  Parker  Willis,  A.B.,  Ph.D. 

The  Federal  Reserve  Act,  passed  by  Congress  on 
December  23, 1913,  is  the  outcome  of  a  discussion  of 
banking  conditions  extending  more  or  less  sporad- 
ically over  the  years  since  the  Civil  War,  but  assum- 
ing an  increasing  degree  of  urgency  from  and  after 
the  panic  of  1893. 

The  National  Banking  System  had  been  estab- 
lished during  the  Civil  War,  partly  as  the  result  of 
the  Government's  financial  necessities  of  that  period. 
It  was,  before  the  adoption  of  the  new  act,  a  system 
of  independent  and  unrelated  banks  with  capitals 
varying  from  $25,000  to  $25,000,000,  holding  out, 
practically  irrespective  of  any  definite  principles,  to 
any  group  of  five  individuals  the  right  to  organize 
and  incorporate  under  its  terms.  Its  characteristic 
feature,  apart  from  this  competitive  and  independent 
aspect,  lay  in  its  provision  for  the  issuance  of  cur- 
rency protected  hj  the  bonds  of  the  National  Gov- 
ernment which  were  required  to  be  purchased  by 
each  bank,  as  organized,  to  an  amount  not  exceeding 
its  capital  stock,  and  not  less  than  certain  specified 
sums.  Such  bonds  were  then  to  be  deposited  with 
the  Treasury  Department  to  safeguard  the  note  cir- 
culation of  the  depositing  bank. 

Defects  in  the  system  very  early  began  to  make 

5 


6  BLACKSTONE  LEGAL  TRAINING  LECTURE 

themselves  manifest.  The  currency  proved  to  be 
wholly  inelastic,  while  the  lack  of  relationship  be- 
tween the  banks  reduced  public  confidence  in  the  sol- 
vency of  the  various  institutions  in  times  of  panic  or 
stress.  Owing  to  such  absence  of  confidence,  individ- 
ual banks  were  frequently  assailed  by  withdrawals  of 
cash  leading  to  the  familiar  ^^runs"  upon  them,  and 
these  often  aggravated  financial  crises.  Although, 
therefore,  sufficiently  effective  in  times  of  financial 
ease  and  quiet,  the  National  Banking  System  had 
entirely  failed  to  furnish  protection  to  the  country 
at  periods  of  stringency,  over-expansion,  or  weak- 
ened reserves,  while  its  currency  was  inadequate  and 
unsatisfactory. 

THE  ALDRICH-VREELAND  ACT 

Many  bills  for  the  reformation  of  the  banldng  sys- 
tem were  proposed  during  the  years  from  1893  to 
1913,  but  practically  the  only  step  taken  by  Congress 
(apart  from  some  purely  incidental  provisions  in  the 
Gold  Standard  Act  of  1900)  was  the  Aldrich-Vree- 
land  Act  of  1908,  wherein  it  was  provided  that  special 
emergency  notes  might  be  issued  upon  security  of 
bonds  other  than  national,  under  certain  conditions, 
as  well  as  upon  commercial  paper  deposited  with 
so-called  ^'national  currency  associations''  composed 
of  the  associated  national  banks  of  a  given  city  or 
locality.  The  intent  of  the  Aldrich-Vreeland  Act  was 
to  furnish  an  expansive  element  in  the  note  circula- 
tion, designed  to  meet  emergency  calls  for  new  or 
additional  currency,  but  it  was  never  called  into  prac- 
tical operation  until  just  before  the  time  at  which  the 
measure  was  to  expire,  shortly  after  the  opening  of 
the  European  war,  which  began  in  August,  1914. 


THE  FEDERAL  RESERVE  SYSTEM  7 

GENERAL  SCOPE  OF  THE  FEDERAL  RESERVE  ACT 

The  Federal  Reserve  Act  was  intended  not  only  to 
meet  this  demand  for  an  elastic  currency,  but  to  elim- 
inate the  chief  sources  of  weakness  in  the  old  system, 
and  at  the  same  time  to  reorganize  the  whole  banking 
resources  of  the  country.  Its  fundamental  thought 
was  the  organization  of  the  existing  banks  of  the 
country  into  homogeneous  groups,  each  of  which 
groups  was  to  establish  a  cooperative  or  ** central" 
institution,  whose  duty  it  should  be  to  issue  notes, 
hold  reserves,  and  rediscount  for  the  individual  or 
member  banks  of  such  group. 

Creation  of  Banking  Districts. — The  Act  according- 
ly provided  for  a  division  of  the  country  into  not 
over  twelve  separate  districts,  -in  each  of  which  the 
member  banks  should  subscribe  6  per  cent  of  their 
capital  and  surplus  to  the  capital  stock  of  an  in- 
stitution to  be  known  as  the  Federal  reserve  bank 
of  the  district.  One-half  of  this  6  per  cent,  or  3  per 
cent,  was  to  be  actually  paid  in,  and  no  Federal  re- 
serve bank  was  to  be  opened  unless  it  had  a  sub- 
scribed capital  of  not  less  than  $4,000,000,  implying, 
therefore,  a  paid-up  capital  of  at  least  $2,000,000. 

Deposit  of  Reserves. — The  Act  required  that  a  spec- 
ified percentage  of  the  reserves  required  of  member 
banks  should  be  deposited  with  the  Federal  reserve 
banks  and  should  be  kept  there.  This  deposit  of  re- 
serves could  be  effected  by  actually  placing  cash  with 
the  reserve  bank,  or  by  presenting  to  it  for  redis- 
count, paper  of  specified  kinds.  The  supervision  of 
all  the  banks  was  vested  in  an  organization  to  be 
appointed  by  the  President  of  the  United  States,  and 
known  as  the  Federal  Reserve  Board,  whose  head- 
quarters were  afterward  located  at  Washington,  D.  C. 


8         BLACKSTONE  LEGAL  TRAINING  LECTURE 

Subsequently,  as  a  war  measure,  it  was  required 
that  all  reserves  be  placed  with  Federal  Reserve 
banks,  while  the  required  reserve  percentage  was 
set  at  13  per  cent  of  demand  deposits  for  banks  in 
central  reserve  cities,  10  per  cent  for  banks  in  re- 
serve cities,  7  per  cent  for  banks  elsewhere. 

Foreign  Trade  Acceptances.  —  The  Act  further 
granted  permission  to  national  banks  to  embark  upon 
a  new  kind  of  business  not  previously  open  to  them, 
that,  namely,  of  accepting  or  guaranteeing  the  paper 
of  importers  and  exporters  engaged  in  the  foreign 
trade  of  the  United  States.  As  a  further  assistance 
to  foreign  trade,  national  banks  of  sufficient  cap- 
italization were  authorized  to  obtain  permission  from 
the  Federal  Reserve  Board  to  open  branches  in  for- 
eign countries.  Later,  an  amendment  to  the  Act 
passed  in  1917  authorized  national  banks  to  take 
stock  in  institutions  to  be  created  for  the  purpose 
of  engaging  in  foreign  trade  banking. 

Refunding  of  Bonds. — The  bond-secured  currency 
had  been  inelastic  and  unsatisfactory;  and  it  was 
feared  that,  as  new  currency  was  issued  by  the 
Federal  reserve  banks  it  might  tend  to  displace  the 
national  bank  currency  and  so  inflict  losses  upon 
the  member  banks  which  had  paid  high  prices  for 
the  2  per  cent  bonds  in  the  belief  that  they  would 
continue  to  be  accepted  as  protection  for  national 
bank  notes,  and  would  thus  enjoy  an  artificial  market 
or  demand.  Therefore,  the  Act  made  provision  for 
the  gradual  refimding  of  these  2  per  cent  bonds  into 
3's,  at  rates  of  conversion  to  be  determined  by  the 
Secretary  of  the  Treasury,  while  it  also  authorized 
the  Federal  Reserve  Board  to  require  Federal  re- 
serve banks  to  purchase  $25,000,000  each  year  of 
such  2  per  cent  bonds. 


THE  FEDERAL  RESERVE  SYSTEM  9 

A  variety  of  other  changes  of  relatively  minor  im- 
portance were  made  in  the  existing  banking  laws 
of  the  United  States,  but  in  substance  the  National 
Banking  Act  was  left  untouched,  the  Federal  reserve 
system  being  simply  introduced  as  a  means  of  co- 
ordinating and  combining  the  already  existing  in- 
stitutions. This,  in  outline,  was  the  form  in  which 
the  Act  was  passed  on  December  23,  1913,  as  al- 
ready stated,  although  for  the  sake  of  completeness 
reference  has  been  incidentally  made  to  some  later 
amendments. 

Domestic  Trade  Acceptances. — Subsequently  some 
amendatory  legislation  was  enacted,  the  first  being 
the  law  adopted  September  7,  1916.  In  this  act  of 
September  7,  provision  was  made  for  the  use  of  the 
domestic  acceptance  through  clauses  permitting 
banks  to  accept  drafts  not  only  in  foreign  trade,  but 
also  in  domestic  business,  provided  that  each  draft 
was  protected  by  actual  documents.  The  Federal 
Reserve  Board  was  also  authorized  to  permit  mem- 
ber banks  to  carry  as  much  of  their  reserves  as 
they  saw  fit,  over  and  above  the  required  amount, 
in  the  vaults  of  the  Federal  reserve  banks.  Some 
minor  additional  changes  also  were  made  in  the 
Federal  Reserve  Act  by  the  terms  of  the  act  of  Sep- 
tember 7,  but  these  were  not  comparable  in  impor- 
tance to  the  two  just  referred  to.  In  1917  the  reserve 
change  already  mentioned  on  page  8  was  introduced, 
while  in  1919  provision  was  made  for  a  new  class 
of  foreign  banks  with  Federal  charters,  intended  to 
help  in  the  reorganization  of  business  on  a  post-war 
basis. 


10       BLACKSTONE  LEGAL  TRAINING  LECTURE 

ORGANIZATION  OF  FEDERAL  RESERVE  BANES 

The  Federal  Reserve  Act  being  a  constructive 
statute  and  not  purely  negative  or  prohibitory  in 
character,  it  was  necessary  to  provide  for  the  or- 
ganization of  the  various  new  institutions  that  had 
been  authorized.  Foreseeing  this  necessity,  the  fram- 
ers  of  the  Act  had  provided  that  a  so-called  '' Organ- 
ization Committee"  should  divide  the  country  into 
districts,  organizing  a  bank  in  each  district.  Short- 
ly after  January  1,  1914,  the  organization  thus  pro- 
vided for  began  its  task,  assisted  by  a  committee  of 
experts  to  whom  was  entrusted  the  technical  and 
scientific  part  of  the  work.  The  Act  had  required 
the  creation  of  not  less  than  eight  nor  more  than 
twelve  districts,  and  the  committee  determined  to 
establish  the  full  number.  Members  of  the  Fed- 
eral Reserve  Board  were  appointed  and  took  office  on 
August  10, 1914,  immediately  proceeding  to  complete 
the  work  of  the  Organization  Committee  by  designat- 
ing Government  directors  for  each  of  the  several  re- 
serve banks.  These  were  to  be  three  in  number  in 
every  case,  the  total  number  of  directors  at  each  bank 
being  nine,  six  of  whom  were  to  be  selected  by  the 
stockholders  of  the  reserve  bank.  The  selection  of 
Government  directors  having  been  completed,  the 
sixteenth  of  November,  1914,  was  set  as  the  date  for 
the  opening  of  the  new  institutions,  and  payments  of 
capital  stock  and  reserves  were  ordered  to  be  on 
hand  on  or  before  that  date. 

INDIVmUAL  ORGANIZATION  OF  BANES 

Partly  as  the  result  of  law,  and  partly  as  deter- 
mined by  the  regulations  and  by-laws  of  the  banks. 


THE  FEDERAL  RESERVE  SYSTEM  11 

each  Federal  reserve  bank  assumed  the  following 
form  of  organization: 

The  Board  of  Directors. — ^Each  bank  was  controlled 
by  a  board  of  directors  consisting  of  nine  mem- 
bers. Of  these  nine,  three  were  chosen  by  the 
member  banks  of  the  district,  voting  in  three 
groups  made  up  according  to  capitalization,  one 
member  being  selected  as  representative  of  the 
banks  of  each  such  group;  three  other  members 
were  selected  by  the  banks  just  as  before,  ex- 
cept that  they  were  to  be  business  men  and  not 
bankers;  and  three  members  were  chosen  by  the 
Federal  Reserve  Board  at  Washington  on  behalf  of 
the  Government.  Of  the  last  or  Government-selected 
group  of  three,  one  was  designated  as  *^  Federal  re- 
serve agent''  and  chairman  of  the  board,  while  a 
second  was  designated  as  deputy  Federal  reserve 
agent  and  deputy  chairman.  The  operation  of  the 
bank  was  placed  in  the  hands  of  an  officer  entitled 
^* Governor,''  chosen  by  the  board  of  directors,  and 
in  most  cases  this  officer  was  assisted  by  one  or  more 
deputy  Governors.  A  re^ar  bank  organization,  in- 
cluding cashier,  tellers,  clerks,  bookkeepers,  etc.,  etc., 
was  developed  along  ordinary  banking  lines.  Each 
board  of  directors  appointed  committees,  an  execu- 
tive committee  being  in  charge  of  business  between 
regular  meetings  of  the  board  of  directors. 

The  Federal  Reserve  Agent. — The  Federal  reserve 
agent  was  in  charge  of  commucdcations  with  the  Fed- 
eral Reserve  Board,  and  was  custodian  of  Federal  re- 
serve notes  obtained  from  Washington  upon  applica- 
tion to  the  Federal  reserve  bank.  To  him  was  as- 
signed, in  addition  to  his  statutory  function  as  chair- 
man of  the  board  of  directors,  many  duties  in  shaping 
general  policies  and  representing  the  bank  in  various 
ways. 


12        BLACKSTONE  LEGAL  TRAINING  LECTURE 

The  Governor, — The  Governor  of  the  bank  was  to 
have  principal  charge  of  relations  with  member 
banks,  receiving  from  them  their  deposits  of  reserves 
and  passing  upon  applications  for  discounts,  pur- 
chases of  paper  and  the  like.  He  was  the  head  of  the 
banking  organization. 

General  Control  by  the  Federal  Reserve  Board. — 
Both  the  bank  and  the  Federal  reserve  agent  were  to 
report  daily  to  the  Federal  Reserve  Board,  giving 
any  essential  details  that  might  be  called  for  by  con- 
ditions. The  Federal  Reserve  Board  fixed  the  salary 
of  the  reserve  and  the  deputy  reserve  agents,  and  its 
approval  was  required  in  the  case  of  all  other  sala- 
ries. The  banks  were  to  be  operated  on  a  uniform 
basis  under  regulations  to  be  supplied  by  the  Federal 
Reserve  Board  from  time  to  time,  while  rates  of  dis- 
count— ^perhaps  the  most  important  function  in  con- 
nection with  the  banks'  operation — were  weekly 
recommended  by  the  board  of  directors  and  subse- 
quently submitted  to  the  Federal  Reserve  Board  for 
its  approval,  becoming  effective  when  such  approval 
had  been  granted,  but  not  sooner. 

EQUIPMENT  OF  INDIVIDUAL  BANKS 

Each  Federal  reserve  bank  equipped  itself  with  a 
suitable  of&ce,  vault,  fixtures  and  the  like,  but  at  the 
outset  it  was  not  thought  well  to  purchase  buildings. 
Subsequently  Federal  reserve  banks  established 
branches  equipped  like  a  Federal  reserve  bank,  but 
acting  under  direction  of  the  parent  institution.  At 
present  the  total  number  of  branches  is  twenty-one, 
located  in  nine  districts,  there  being  three  districts 
without  branches. 


THE  FEDERAL  RESERVE  SYSTEM 


13 


14        BLACKSTONE  LEGAL  TRAINING  LECTURE 

The  foregoing  map  presents  a  rough  general  out- 
line of  the  districts  as  existing  at  the  middle  of  the 
year  1920.  Following  is  a  condensed  statement  of 
the  condition  of  the  system : 

Principal  asset  and  Uahility  items  of  the  12  Federal  Beserve 
Banks  combined  on  Sept-ember  2d,  1980. 

[In  millions  of  dollars.] 

Sept.  24  Sept.  24 

Reserves:                                                    Total  earning  assets 3,310 

Total    2,152       Government    deposits 46 

Gold     1,990  Members '    reserve    deposits. .  1,801 

Bills   discounted :                                        Net    deposits 1,658 

Total    2,704  Federal  Eeserve  notes  in  cir- 

Seeured      by      Government                          culation 3,280 

■war  obligations 1,220  Federal    Eeserve    Bank   notes 

All  other 1,484               in    circulation 214 

Bills  bought  in  open  market .  308       Eeserve  percentage 43.6 

Certificates    of    indebtedness.  271 

EARLY  PROBLEMS  OF  THE  SYSTEM 

The  new  system  had  come  into  existence  at  a 
very  critical  time  in  American  financial  history.  At 
the  opening  of  the  European  war  and  while  the 
task  of  selecting  and  confirming  the  members  of  the 
Board  was  still  in  progress,  there  had  begun  an  im- 
portant movement  of  gold  out  of  the  country  for  the 
purpose  of  liquidating  debts  owed  to  persons  in  the 
belligerent  countries  of  Europe.  This  movement  had 
caused  anxiety  among  the  banks,  and  specie  pay- 
ments had  been  practically  suspended  in  many  parts 
of  the  United  States.  Emergency  notes,  under  the 
terms  of  the  Aldrich-Vreeland  Act,  as  promptly 
amended  by  Congress,  had  been  issued  to  meet  these 
difficulties,  and  the  opening  of  the  new  banks  found 
the  nation  at  large  in  an  uncertain  and  depressed  con- 
dition with  little  demand  for  loans,  and  with  a  super- 
abundant note  currency  amounting  to  some  $400,000,- 
000,  not  issued  by  the  Federal  reserve  banks  them- 
selves but  put  out  under  the  Aldrich-Vreeland  Act  as 


THE  FEDERAL  RESERVE  SYSTEM  15 

amended,  still  in  circulation.  The  first  task  of  the 
new  reserve  banks  was  to  assist  member  banks  in 
retiring  such  emergency  currency,  and  in  this  they 
were  of  substantial  service. 

The  country  had  hardly  been  restored  to  a  normal 
currency  basis,  however,  when  heavy  demands  of  for- 
eign nations  for  our  products  produced  a  reverse 
movement  in  international  trade,  and  gold  began  to 
flow  into  the  United  States  instead  of  away  from  the 
country.  In  consequence  the  reserves  of  member 
banks  were  continuously  high,  and  they  were  not  in 
need  of  much  extra  accommodation,  so  that  their  de- 
mands upon  Federal  reserve  banks  for  the  services 
of  the  latter  were  naturally  small.  This  obviated  the 
need  of  any  reliance  for  the  time  upon  Federal  Re- 
serve banks  and  of  course  eliminated  opportunities  of 
earning  which  would  otherwise  have  been  open  to  the 
latter,  but  it  gave  the  reserve  banks  and  the  Federal 
Reserve  Board  full  opportunity  to  perfect  their  reg- 
ulations and  methods  of  doing  business  before  the 
advent  of  any  period  of  exceptional  stress. 

OPENING  OP  THE  WAR 

Such  a  period  of  stress,  however,  was  not  slow  in 
developing.  It  had  been  evident  for  some  time  after 
the  opening  of  the  year  1917  that  the  United 
States  would  be  likely  to  be  drawn  into  the  European 
war  in  some  way  and  such  in  fact  proved  to  be  the 
case,  war  being  declared  on  April  6.  The  declara- 
tion of  war  was  necessarily  the  signal  for  the  accept- 
ance of  very  great  responsibility  by  the  banking  sys- 
tem. It  was  evident  from  the  outset  that  even  with 
the  heaviest  taxation  that  could  be  borne  by  the  com- 
munity it  would  be  necessary  for  the  Treasury  to 
obtain  a  very  large  part  of  the  resources  needed  to 


16        BLACKSTONE  LEGAL  TRAINING  LECTURE 

pay  the  expense  of  the  war  through  loans.  As  time 
went  on  it  became  equally  apparent  that  such  loans 
could  not  be  provided  for  by  any  means  already 
familiar  to  the  conmiunity,  but  that  they  must  be 
floated  through  the  development  of  a  new  and  very 
inclusive  system  of  distribution.  This  led  to  the 
creation  of  the  so-called  Liberty  Loan  organization 
which  ultimately  extended  its  ramifications  through- 
out the  United  States,  but  it  was  soon  apparent  that 
even  these  organizations  would  not  be  able  to  place 
the  bonds  unless  they  had  direct  assistance  from  the 
banks,  which  in  turn  would  be  obliged  to  fall  back 
upon  the  Federal  Reserve  banks. 

The  handling  of  war  loans  as  fiscal  agents  for  the 
United  States,  the  issuance  of  temporary  and  perma- 
nent bonds,  the  receipt  of  subscriptions,  the  shifting 
of  the  Government's  funds  from  place  to  place,  and 
most  important  of  all,  the  rediscounting  of  paper 
representing  advances  made  by  banks  upon  the 
security  of  Government  obligations,  became  the 
principal  functions  of  the  Federal  Reserve  banks. 
It  was  an  unfortunate  fact  that  the  first  great  ex- 
pansion of  its  operations  which  was  experienced 
by  the  Federal  Reserve  system  came  as  the  result, 
not  of  ordinary  or  normal  business  requirements, 
but  in  consequence  of  those  growing  out  of  war 
demands.  As  the  Government,  however,  gradually 
extended  the  scope  of  its  control  over  business 
operations  of  every  kind,  and  as  business  became 
more  and  more  engaged  in  filliag  Government 
orders,  the  financing  of  the  Government's  war  re- 
quirements became  more  and  more  largely  a  process 
of  financing  the  business  of  the  country,  through 
new  and  unaccustomed  methods  of  approach. 

The  years  1917-1919  were  accordingly  a  period 
within  which  the  nature  of  the  nation's  busiQess  was 


THE  FEDERAL  RESERVE  SYSTEM  17 

being  gradually  transformed,  while  a  new  basis  for 
the  financing  of  it  was  being  supplied.  In  this  process 
the  Federal  Reserve  banks  underwent  a  very  great 
expansion  both  of  their  personnel  and  of  their  opera- 
tions. The  statement  given  on  page  14  shows  the  con- 
dition of  the  system  as  it  existed  in  September,  1920, 
indicates  the  scope  of  the  expansion  of  the  banks* 
operations,  for  the  war,  although  ended  in  a  military 
sense  at  the  time  of  the  armistice  on  November  11, 
1918,  was  not  in  a  financial  sense  near  its  close.  Not 
only  was  one  of  the  great  war  loans  (the  Victory 
Loan  of  1919)  floated  more  than  four  months  after 
the  conclusion  of  the  armistice,  but  the  Government's 
regular  expenses  went  on  mounting  during  the  first 
six  months  of  1919,  due  to  the  fact  that  many  com- 
mitments, such  as  soldiers'  pay  and  the  like,  had  to 
be  met.  The  gradual  decline  of  the  war  demands 
was  not,  as  some  had  expected,  followed  by  an  equal 
reduction  in  the  scope  of  the  operations  of  Reserve 
banks. 

Instead  of  the  business  depression  which  some 
had  predicted  as  the  immediate  successor  to  the 
close  of  the  war,  a  period  of  speculation  and  in- 
flated business  transactions  ensued  in  the  United 
States,  and  this  inflation  period  was  unfortunately 
financed  in  large  measure  through  the  use  of  funds 
which  should  have  been  employed  in  reducing  the 
banking  commitments.  Such  funds  were  to  no  small 
degree  obtained  from  Federal  Reserve  banks  by  con- 
tinuing the  practice  of  rediscounting  paper  coUat- 
eraled  by  Government  obligations.  Accordingly,  the 
transactions  of  the  system  continued  to  increase  in 
size,  reaching  their  present  great  magnitude,  as  al- 
ready illustrated  by  the  statement  shown  on  page  14. 


18        BLACKSTONE  LEGAL  TRAINING  LECTURE 

To-day  the  holdings  of  Federal  Reserve  banks 
are  to  the  extent  of  about  one-half  composed  of  so- 
called  war  paper,  that  is  to  say,  paper  coUateraled 
by  Government  obligations,  while  they  are  to  the 
extent  of  about  one-half  composed  of  commercial 
paper,  including  bankers'  acceptances,  commercial 
bills,  and  other  obligations. 

DISCOUNT  RATE  POLICY 

The  outstanding  feature  of  reserve  policy  during 
the  war  was  seen  in  connection  with  the  establish- 
ment of  discount  rates.  Prior  to  our  entry  into  the 
struggle  the  discount  rate  question  had  not  been  of 
very  much  importance.  Although  it  was  true  that 
Federal  Reserve  banks  almost  from  the  beginning 
established  a  rate  for  the  rediscount  of  paper  which 
was  under  the  market  rate,  thereby  allowing  a  small 
margin  of  profit  to  a  banker  who  might  choose  to 
place  paper  with  the  reserve  institution,  this  phase  of 
policy  also  had  been  of  comparatively  little  import- 
ance. When  the  reserve  act  was  passed  it  provided 
for  a  lower  basis  of  reserves  than  that  which  existed 
at  the  time,  warranting  itself  in  so  doing  by  the  fact 
that  the  greater  economies  of  reserve  permitted  by 
the  system  would  allow  the  relaxation  of  the  more  or 
less  stringent  legal  requirements  which  had  pre- 
viously maintained  the  holdings  of  cash  at  what 
seemed  an  unnecessarily  high  point.  The  effect  of 
this  ^^ release  of  reserves''  was  to  place  in  the  hands 
of  the  banks  a  very  large  lending  power  which  they 
were  able  to  employ  in  expanding  their  operations. 
As  a  matter  of  fact  they  did  largely  increase  their 
dealings  on  the  strength  of  this  greater  capacity  for 
lending,  and  with  this  broader  power  of  operation  it 
was  not  necessary  (as  already  pointed  out)  for  them 
to  do  much  rediscounting  at  any  price,  so  that  the 


THE  FEDERAL  RESERVE  SYSTEM  19 

Reserve  banks  had  practically  no  control  over  the 
discount  market  or  the  rate  of  interest.  There  had 
been  some  modification  in  this  condition  shortly  be- 
fore the  entry  of  the  United  States  into  the  war,  due 
to  the  fact  that  the  **  slack  "provided  through  the 
lowering  of  reserve  requirements  had  been  very 
largely *Haken  up."  In  the  opinion  of  some, therefore, 
the  first  three  or  four  months  of  the  year  1917  were 
characterized  by  the  development  of  a  certain  power 
over  the  money  market  which  the  reserve  system 
had  never  before  possessed.  Be  this  as  it  may,  the 
period,  whatever  it  was,  within  which  the  system 
was  able  to  exert  such  control  was  very  short. 

At  the  opening  of  the  war  the  fundamental  question 
in  the  financial  world  was  necessarily  the  rate  at 
which  the  new  Government  bonds  were  to  be  floated. 
It  was  necessary  that  this  rate,  whatever  it  might  be, 
should  practically  dictate  the  discount  rate  to  be 
fixed  by  the  Reserve  banks,  for  in  the  event  that  the 
banks  declined  to  rediscount  at  a  rate  generally  cor- 
responding to  the  rate  on  the  bonds,  prospective  buy- 
ers would  be  somewhat  discouraged  from  buying  and 
paying  for  them  on  the  instalment  plan,  since  there 
would  be  a  distinct  item  of  cost  for  ^'carrying"  the 
securities.  It  was  therefore  considered  by  the  author- 
ities of  the  United  States  Treasury  very  essential  to 
have  the  rediscount  rate  at  Reserve  banks  corre- 
spond to  the  rate  borne  by  the  new  loans. 

In  the  first  Liberty  loan  the  rate  of  3%  per  cent 
paid  on  the  bonds  was  accordingly  paralleled  by  a  3% 
per  cent  rate  on  notes  based  upon  such  bonds,  and  as 
the  subsequent  issues  of  Government  securities  came 
upon  the  market  at  gradually  rising  rates  of  interest, 
a  corresponding  advance  in  the  rate  of  discount  at 


20        BLACKSTONE  LEGAL  TRAINING  LECTURE 

Reserve  banks  was  made.  During  the  latter  part 
of  the  war,  however,  the  advance  in  rates  at  Federal 
Reserve  banks  was  somewhat  ** slowed  down''  and 
the  rate  was  kept  constantly  a  little  below  that  borne 
by  the  bonds.  This  afforded  a  certain  element  of 
profit  to  those  banks  which  were  holders  of  bonds, 
Government  notes  or  Treasury  certificates  of  in- 
debtedness. 

CHAEAGTEB  OF  PAPER  ELIGIBLE  FOR  PRESENTATION 

The  Federal  Reserve  Act  has  given  to  the  Board 
the  power,  subject  to  broad  general  restrictions,  to 
define  the  character  of  paper  eligible  for  presenta- 
tion to  Federal  reserve  banks  as  a  basis  for  discount. 
That  body  ultimately  defined  certain  types  of  such 
paper,  including  among  them  the  bankers'  accept- 
ance or  draft  accepted  by  a  banker,  the  trade  accept- 
ance or  bill  or  draft  accepted  by  an  individual  or  a 
concern,  the  single-name  or  *^ straight"  note,  the  for- 
eign bill,  and  so-called  ^'commodity  paper"  or  paper 
coUateraled  by  warehouse  receipts  representing 
staple  products. 

Each  of  these  classes  of  paper  had  to  conform  to 
two  basic  requirements:  (1)  It  must  grow  out  of 
actual  bona  fide  commercial  transactions;  (2)  it  must 
not  exceed  specified  maturities — 90  days  for  com- 
mercial paper,  180  days  for  agricultural  paper,  and 
similar  periods  for  bankers'  acceptances  growing  out 
of  foreign  trade.  The  fact  quickly  developed  that 
the  commercial  paper  of  the  country  was  in  such  a 
condition  as  to  call  for  considerable  readjustment 
in  order  to  bring  it  strictly  within  the  prescribed 
form  laid  down  by  the  Board.  This  necessitated 
further  readjustment  of  the  Board's  regulations,  and 


THE  FEDERAL  RESERVE  SYSTEM  21 

rectification  of  various  practices  in  connection  with 
the  creation  of  commercial  paper  itself.  Rediscount 
operations,  however,  continued  to  be  upon  a  small 
scale  for  two  years  or  more. 

Under  the  ^^open  market''  provisions  of  the  law 
it  had  been  provided  that  Federal  reserve  banks 
might  buy  from  individuals,  corporations,  or  banks 
whether  or  not  members  of  the  system,  any  paper 
that  they  might  choose,  provided  that  it  complied 
with  the  requirements  for  discountable  paper.  The 
banks  bought  considerable  quantities  of  Government 
bonds,  mimicipal  warrants  and  bankers'  acceptances, 
and  smaller  amounts  of  trade  acceptances.  In  this 
way  their  earning  assets  were  increased  until  at  the 
end  of  the  year  1916  they  had  about  $200,000,000  in- 
vested. At  the  close  of  1916  a  summary  of  the  entire 
operation  of  the  system  since  its  opening — about  two 
years — showed  that  a  net  earning  above  organization 
expenses  had  been  made  of  approximately  2.7  per 
cent  on  the  capital.  During  the  period  in  question 
gross  earnings  had  been  approximately  $6,475,000, 
and  net  earnings  approximately  $2,680,000.  The 
bank  which  had  paid  the  largest  dividend  was  the 
Federal  Reserve  Bank  of  Richmond,  which  had  prac- 
tically completed  its  whole  6  per  cent  dividend,  ac- 
tually declaring  and  paying  it  to  November  1, 1916. 

WAB  EXPANSION 

This  first  period  of  modest  earnings  and  limited 
operation,  during  which  the  Federal  Reserve  system 
was  chiefly  occupied  with  problems  of  organization 
and  in  which  its  purchases  of  paper  were  compara- 
tively   small — hardly    more    than    experimental — 


22        BLACKSTONE  LEGAL  TRAINING  LECTURE 

would  naturally  have  come  to  a  close  when  the  sur- 
plus lending  power  of  the  member  banks  which  had 
been  set  free  through  the  lowering  of  reserve  require- 
ments in  the  Federal  Reserve  Act  had  been  absorbed 
and  when,  therefore,  the  natural  expansion  of  busi- 
ness led  the  members  to  fall  back  upon  Federal  Re- 
serve institutions  for  assistance.  Exactly  how  long 
this  process  would  have  required  it  would  be  difficult 
to  say,  but  it  would  certainly  have  been  a  slow  and 
gradual  expansion.  The  determination  of  the  United 
States  to  enter  the  war  brought  the  early  period  to 
a  close  and  forced  the  Federal  Reserve  system  to 
enter  upon  an  epoch  of  very  great  and  rapid  growth 
instead  of  awaiting  the  slower  development  which 
would  have  been  experienced  imder  ordinary  con- 
ditions. 

It  had  been  apparent  from  the  close  of  the  year 
1916  that  the  United  States  was  likely  to  be 
drawn  into  the  European  war  by  some  means,  a  fact 
which  actually  came  to  pass  in  April,  1917.  Even 
before  the  actual  declaration  of  war,  the  demands 
of  member  banks  had  begun  to  increase  quite  dis- 
tinctly, so  that  it  was  the  opinion  of  authorities  in 
the  Federal  Reserve  system  that  the  control  over 
discount  rates  which  it  had  been  supposed  would  be 
exerted  by  Federal  Reserve  banks  had  become  real. 
This  could  not  be  the  case  as  long  as  the  operations 
of  the  members  were  very  small  so  that  the  redis- 
count rate  at  Reserve  banks  was  only  sporadically 
availed  of.  As  the  demands  of  the  member  banks 
began  to  increase  consequent  upon  the  enlargement 
of  their  own  operations,  and  perhaps  in  some  meas- 
ure due  to  a  desire  to  strengthen  themselves  and 
their  customers  with  a  view  to  possible  war  develop- 
ments, the  authority  of  the  Federal  Reserve  rate 
came  to  be  more  and  more  generally  recognized. 


THE  FEDERAL  RESERVE  SYSTEM  23 

Another  factor  which  tended  to  increase  the  in- 
fluence of  the  Reserve  banks  was  furnished  by  the 
decision  of  the  Treasury  Department  to  take  ad- 
vantage of  the  provision  of  the  Act  which  authorized 
the  Reserve  banks  to  act  as  fiscal  agents  for  the  Gov- 
ernment. This  was  put  into  effect  on  the  first  of 
January,  1917,  and  immediately  resulted  in  trans- 
ferring all  Government  funds  to  the  Reserve  banks 
in  those  cities  in  which  the  Reserve  banks  were  sit- 
uated. Treasury  deposits,  however,  were  retained 
in  the  smaller  banks  outside  of  the  Reserve  bank 
cities. 

The  first  effect  of  the  advent  of  the  United  States 
as  a  participator  in  the  European  war  was  to  make 
it  evident  that  there  would  have  to  be  an  immense 
flotation  of  bonds  and  short-time  Government  ob- 
ligations for  the  purpose  of  providing  the  Treasury 
with  the  means  of  meeting  the  demands  upon  it. 
This,  of  course,  had  been  foreseen,  but  it  had  not  been 
understood  that  the  heavy  demands  thus  to  be  ex- 
pected would  be  brought  to  bear  almost  at  once  be- 
cause of  the  fact  that  the  European  countries  had 
reached  a  point  which  necessitated  immediate  finan- 
cial aid.  At  the  very  outset  of  our  participation 
in  the  war,  therefore,  Federal  Reserve  banks  were 
called  upon  to  supply  the  Treasury  with  the  funds 
it  required  and  to  get  them  back  by  redistributing 
Treasury  obligations  to  member  banks.  In  so  doing, 
as  the  Government's  poKcy  gradually  worked  out,  it 
really  undertook  to  anticipate  collections  to  be  ob- 
tained from  the  rank  and  file  of  the  population,  partly 
through  taxes  and  partly  through  the  sale  of  long- 
term  bonds,  afterward  known  as  Liberty  bonds.  The 
process  of  formulating  and  enacting  a  tax  measure 


24        BLACKSTONE  LEGAL  TRAINING  LECTURE 

is,  however,  always  slow,  and  the  machinery  re- 
quired for  the  placing  of  a  great  loan  of  the  kind 
afterward  familiar  under  the  head  of  Liberty  loans, 
is  by  no  means  speedy.  It  was  therefore  evident 
that  the  Federal  Reserve  banks  and  their  members 
would  have  to  sustain  a  very  large  burden  of  float- 
ing indebtedness  for  a  good  while  to  come. 

Those  who  were  in  charge  of  the  financing  recog- 
nized from  the  outset  the  desirability  of  having  the 
rank  and  file  of  the  population  absorb  these  obliga- 
tions as  fast  as  practicable,  but  it  was  also  recognized 
that  rapid  absorption  of  that  kind  was  hardly  to  be 
expected.  Even  to  get  the  banks  of  the  country  to 
take  the  Government's  obligations  as  an  interme- 
diate step  to  their  distribution  to  the  public  meant 
that  the  banks  must  be  assured  of  some  means  of  re* 
couping  themselves,  in  the  event  that  they  either 
became  overburdened  with  the  securities  through 
direct  purchase  or  through  the  discounting  of  paper 
presented  by  their  customers  with  these  obligations 
as  collateral,  or  in  the  event  that  hard-pressed  cus- 
tomers who  had  been  subscribing  heavily  for  public 
bonds  required  consequently  greater  accommodation 
in  order  to  carry  on  their  business.  In  consequence 
of  this  situation,  the  Treasury  practically  required 
the  Federal  Reserve  banks  to  fix  a  rate  for  discount 
for  paper  collateraled  by  Government  obligations 
which  was  not  higher  than  the  rate  on  the  Govern- 
ment obligations  themselves.  This  might  have  done 
no  harm  had  the  rate  on  Government  obligations 
been  allowed  to  go  to  a  figure  which  corresponded 
to  the  commercial  worth  of  money,  but  through  a  de- 
sire to  keep  the  rate  of  interest  as  low  as  possible 
the  first  Liberty  loan  was  sold  at  3%  per  cent  and 


THE  FEDERAL  RESERVE  SYSTEM  25 

the  Reserve  banks  undertook  to  rediscount  at  this 
same  figure  for  banks  which  had  loaned  to  their  cus- 
tomers at  that  rate. 

A  somewhat  similar  policy  was  followed  through- 
out the  succeeding  Liberty  loans,  and  as  time  went 
on  it  became  necessary  for  the  Treasury  to  anticipate 
the  proceeds  of  Liberty  loans  by  selling  what  were 
kno^^^l  as  Treasury  certificates  of  indebtedness. 
These  were  for  a  long  time  put  out  in  blocks 
at  intervals  of  about  two  weeks,  so  that  during 
the  intervals  between  Liberty  loans  the  banks  of 
the  country  would  be  called  upon  to  absorb  great 
quantities  of  Treasury  certificates.  Thus,  when  a 
Liberty  loan  was  floated  the  proceeds  of  the  loan 
would  be  used  to  take  up  the  certificates.  When  the 
proceeds  of  new  heavy  taxes  were  received  they  were 
used  as  far  as  they  would  go  to  pay  off  maturing 
issues  of  certificates  of  indebtedness  as  well  as  cur- 
rent expenses  of  the  Government.  Li  this  way  the 
banking  mechanism  was  drawn  upon  for  the  current 
funds  necessary  to  finance  the  war  and  they  were 
provided  in  advance  of  the  time  when  they  were 
saved,  or  even  subscribed  through  promises  to  pur- 
chase Government  obligations. 

It  was  this  process  which  laid  the  basis  for 
what  came  to  be  known  as  inflation — the  creation  of 
long-term  obligations  in  banks  which  gave  rise  to 
issues  of  currency  and  in  any  event  furnished  the 
basis  of  demand  for  commodities  which  raised  the 
price  of  goods  to  abnormal  figures.  The  operation 
which  has  thus  been  briefly  sketched  necessitated  an 
enormous  expansion  both  in  the  business  and  per- 
sonnel of  Federal  Reserve  banks,  and  consequently 
led  to  a  very  great  increase  in  earnings.    Prior  to 


26        BLACKSTONE  LEGAL  TRAINING  LECTURE 

our  entry  into  the  war  the  total  personnel  of  Federal 
Reserve  banks  did  not  include  more  than  about  850 
individuals.  At  the  close  of  the  year  1919  the  staff 
had  increased  to  more  than  10,000  persons,  and  the 
total  earning  assets  which  at  the  close  of  1916  were 
only  about  one  billion  dollars,  had  risen  at  the  close 
of  1920  to  $6,500,000,000.  Reference  has  already  been 
made  to  the  very  modest  earnings  which  Federal 
Reserve  banks  reported  during  the  first  two  years  of 
the  system.  The  opening  of  the  war  period  with 
its  enormous  expansion  of  operations  immediately 
brought  a  great  growth  both  of  gross  and  net  profits, 
and  for  the  year  1917  the  total  net  earnings,  after  all 
expenses,  for  the  combined  banks  of  the  Federal 
Reserve  system  rose  to  about  20  per  cent,  while  for 
1918  they  reached  about  55  per  cent,  and  for  1919 
about  100  per  cent,  the  actual  net  earnings  in  the 
latter  year  amounting  to  approximately  $80,000,000. 
The  most  recent  reports  of  earnings  covering  the  first 
half  of  the  year  1920  show  a  rate  of  return  on  capital 
which  may  be  roughly  estimated  at  about  150  per 
cent. 

CHANGE  IN  CHARACTER  OF  PAPER 

Brief  description  has  already  been  furnished  as 
regards  the  character  of  paper  which  was  eligible 
for  presentation  at  Federal  Reserve  banks  under  the 
terms  of  the  original  act.  Had  not  the  war  come  on 
as  it  did,  there  would  have  been  good  reason  to  ex- 
pect a  slow,  gradual  development  in  American  com- 
mercial paper  usage,  and  probably  a  slow  alteration 
of  the  kinds  of  paper  composing  the  portfolios  of 
member  banks  of  the  system.  It  had  been  found 
through  experience  during  the  first  two  years  after 
organization  that  the  use  of  the  acceptance  would 


THE  FEDERAL  RESERVE  SYSTEM  27 

probably  proceed  rather  slowly  and  that  its  best 
form  would  doubtless  be  the  bankers'  acceptance 
which  in  turn  would  find  its  most  desirable  use  in 
foreign  trade.  Our  foreign  trade  had  increased  very 
greatly  during  the  first  years  of  the  European  war, 
but  the  financing  of  it  had  been  upon  a  conservative 
basis  and  with  comparatively  little  change  in  the 
types  of  paper  employed  by  our  banks. 

During  the  years  1915  and  1916  only  a  relatively 
small  advance  in  the  use  of  acceptances  was  made, 
while  the  bulk  of  the  paper  which  was  discounted  at 
Federal  Reserve  banks  consisted  of  the  familiar 
straight  single-name  note  which  has  for  many  years 
past  constituted  the  basic  means  of  financing  Amer- 
ican transactions. 

Shortly  after  the  opening  of  the  war  the  increasing 
tightness  of  money  and  the  desire  to  provide  on  a  lib- 
eral scale  for  our  constantly  increasing  export  trade 
brought  about  a  more  liberal  use  of  the  acceptance, 
and  bankers'  acceptances,  both  foreign  and  domestic, 
began  to  appear  in  the  market  in  considerably 
greater  number.  It  was  then  believed  that  tjie  ef- 
fect of  the  war  would  not  only  be  that  of  increasing 
the  amount  of  straight  single-name  paper  discounted 
by  the  banks  and  by  them  rediscounted  with  the 
Federal  Reserve  banks,  but  that  it  would  also  bring 
about  a  very  large  addition  in  the  form  of  accept- 
ances to  the  available  volume  of  paper. 

The  war  financing,  however,  introduced  an  unex- 
pected change  into  the  situation.  This  was  due  to  the 
fact  that  it  was  impossible  to  discriminate  between 
the  purposes  for  which  paper  was  presented.  In  prac- 
tice, there  was  no  feasible  way  of  determining  whether 
a  business  house  which  asked  for  an  advance  and 
offered  Government  bonds  as  collateral  was  doing  so 


28        BLACKSTONE  LEGAL  TRAINING  LECTURE 

in  order  to  subscribe  for  more  Government  bonds  or, 
on  the  other  hand,  was  merely  seeking  to  get  funds 
with  which  to  enlarge  its  plant,  or  even  to  engage  in 
speculative  operations.  The  fact  that  a  special  low 
rate  had  been  made  for  the  paper  collateraled  by  Gov- 
ernment obligations,  and  the  further  fact  that  every 
effort  had  been  made  to  secure  a  very  wide  distribu- 
tion of  Government  obligations  so  that  they  were 
held  by  the  population  throughout  the  country,  im- 
avoidably  involved  the  transference  of  our  bank- 
loan  basis  from  bona  fide  commercial  paper  to  paper 
collateraled  or  protected  by  Government  obligations 
of  various  descriptions.  Soon  after  the  opening  of 
the  war,  therefore,  it  seemed  as  if  the  portfolios  of 
Reserve  banks  might  come  to  consist  almost  entirely 
of  this  so-called  war  paper.  The  development  of  com- 
mercial banking  practice  and  of  the  use  of  commer- 
cial paper  in  general  was  given  a  serious  setback. 

Owing  to  the  restrictions  upon  business,  and  es- 
pecially upon  speculation,  which  were  enforced 
through  legislation  enacted  by  Congress  and  which 
continued  up  to  the  close  of  the  war,  the  influence 
of  inflation  and  the  change  in  the  character  of  paper 
held  by  Reserve  banks  did  not  make  themselves  as 
fully  evident  as  they  would  otherwise  have  done. 
With  the  close  of  the  war,  however,  and  the  resump- 
tion of  active  stock-exchange  operations  not  long 
after,  there  set  in  a  period  of  extreme  speculative 
activity  which  was  the  more  dangerous  because  of 
the  fact  that  rediscoimt  rates  at  Federal  Reserve 
banks  were  for  some  time  kept  at  a  low  level  owing 
to  the  circumstance  that  expenses  actually  increased 
for  a  number  of  months  after  the  war  because  of  the 
commitments  which  had  been  previously  entered 
into.     These  heavy  Government  expenses  necessi- 


THE  FEDERAL  RESERVE  SYSTEM  29 

tated  continual  sales  of  Government  obligations 
which  in  turn  were  thought  to  require  the  same 
methods  of  financing  that  had  been  employed  in  float- 
ing them  during  the  war  period.  At  the  same  time 
immense  demands  for  capital,  partly  for  financing 
our  export  trade,  and  partly  for  the  expansion  of 
industries  which  had  been  held  back  dui^ing  the  war, 
tended  to  raise  ordinary  commercial  rates  of  interest 
both  for  bank  paper  and  for  investment  securities 
while  at  the  same  time  they  led  to  a  search  for  new 
methods  of  financing.  There  was  therefore  during 
the  year  1919-20  a  rapid  growth  in  the  acceptance 
liabilities  of  member  banks  and  an  increasing  tend- 
ency to  diversify  the  character  of  the  paper  held  by 
Federal  Reserve  banks. 

CONTROL  OF  CREDIT 

As  has  been  seen,  any  effort  of  the  Federal  Reserve 
Board  or  system  during  the  war  to  control  the  credit 
situation  had  been  put  out  of  the  question  by 
the  fact  that  it  had  been  obliged  to  make  a  low 
and  preferential  rate  upon  notes  secured  by  Govern- 
ment obligations.  It  was  clear,  however,  that  as  soon 
as  public  financing  was  fairly  well  out  of  the  way 
it  would  be  necessary  to  abandon  this  low  rate  policy. 
In  aU  the  central  banks  of  the  world  experience  has 
shown  that  the  most  available  means  of  controlling 
the  volume  of  credit  is  that  of  varying  the  discount 
rate.  This  is  not  only  because  of  the  influence  of 
such  variations  in  regulating  the  demand  for  loans, 
but  also  because  of  the  leadership  which  is  afforded 
by  such  changes  in  discount  rates — a  warning  thus 
afforded  to  owners  of  capital  as  to  conditions  exist- 
ing in  the  market.    As  a  substitute  for  this  kind  of 


30        BLACKSTONE  LEGAL  TRAINING  LECTURE 

leadership  an  effort  had  been  made  both  by  the  Gov- 
ernmental authorities  and  by  the  officers  of  the  Fed- 
eral Reserve  Board  and  system,  in  cooperation  with 
them,  to  induce  voluntary  rediscount  of  demands  of 
banks  by  stimulating  saving,  cutting  down  imneces- 
sary  production,  and  in  various  other  ways.  Appeals 
of  this  kind  had  been  strengthened  and  supported  by 
the  action  of  Congress  in  passing  an  act  creating 
what  was  called  the  ** capital  issues  committee," 
whose  function  it  was  to  pass  upon  all  prospective 
issues  of  securities,  allowing  those  only  to  receive 
sanction  which  were  regarded  as  representative  of 
essential  or  necessary  goods.  This  plan  could  not 
continue  long  after  the  close  of  the  war  and  the 
work  of  the  capital  issues  committee  was  terminated 
early  in  1919  by  order  of  the  Secretary  of  the 
Treasury. 

It  was  evident,  as  the  war  restrictions  one  after 
another  slipped  away,  that  the  Federal  Reserve 
Board  would  have  to  fall  back  upon  the  discount 
rate  as  a  means  of  credit  control.  An  advance  in 
rates  was  in  fact  initiated  on  the  4th  of  November, 
1919.  Up  to  that  time  the  war  rates  corresponding 
to  those  borne  by  the  Government  obligations  had 
practically  fixed  the  charges  at  Federal  Reserve 
banks.  These  rates  corresponded  to  a  charge  of  about 
4%  per  cent  for  90-day  paper.  The  November  ad- 
vance was  followed  by  other  changes  and  within  the 
succeeding  six  months  the  90-day  rate  had  been 
shifted  practically  to  a  7  per  cent  basis  throughout 
the  country,  while  for  90-day  paper  collateraled  by 
Government  obligations  the  rate  was  6  per  cent. 
Meantime  the  Secretary  of  the  Treasury  had  raised 
the  rate  on  Treasury  certificates  of  indebtedness  to 
6%  per  cent  and  6  per  cent,  according  to  maturity. 


THE  FEDERAL  RESERVE  SYSTEM  31 

The  effect  of  these  changes  was  to  tend  to  reduce  the 
price  of  the  outstanding  Liberty  bonds  in  the  market 
because  they  had  been  originally  issued  at  rates 
which  were  considerably  below  the  real  market  value 
of  money,  while  this  market  value  had  itself  risen 
as  a  result  of  the  destruction  of  capital  during  the 
war.  The  sharp  advance  in  rates  at  Federal  Reserve 
banks  corresponded  to  an  even  greater  advance 
which  had  taken  place  in  the  market  in  the  mean- 
time and  which  carried  the  charge  for  good  commer- 
cial paper  up  to  a  level  of  8  per  cent  or  more  before 
the  first  of  July,  1920,  while  the  best  and  soimdest 
obligations  of  strong  corporations  could  be  marketed 
only  at  a  rate  varying  from  7  to  8  per  cent.  The  appli- 
cation of  these  high  rates  naturally  had  its  effect  in 
restricting  credit  and  in  preventing  the  previously 
unrestrained  growth  of  demands  for  accommodation. 

During  the  war  there  hadbeen  an  enormous  advance 
in  the  liabilities  of  banks  all  over  the  country.  The 
total  deposits  of  all  banks  as  reported  by  the  Comp- 
troller of  the  Currency  rose  from  $12,400,000,000  at 
the  end  of  1916  to  nearly  $23,000,000,000  at  the  end 
of  1919.  It  could  not  be  expected  that  the  mere  appli- 
cation of  higher  discount  rates  by  Federal  Reserve 
banks  would  immediately  restrain  this  growth  of 
credit,  and  as  a  matter  of  fact  there  was  no  reduction 
in  the  total  amoimt  of  credit  granted  during  the  first 
half  of  1920.  The  high  rates  did,  however,  restrain 
applications  for  credit  which  would  otherwise  have 
made  themselves  felt.  On  practically  all  the  stock 
exchanges  of  the  country  operations,  after  the  begin- 
ning of  the  year,  were  reduced  to  a  much  lower  figure 
than  had  been  characteristic  for  a  long  time  past, 
"while  there  was  great  reduction  in  the  speculation  in 


32        BLACKSTONE  LEGAL  TRAINING  LECTURE 

lands  and  in  commodities  that  had  been  rife  all  over 
the  coimtry  during  the  year  1919.  By  about  the 
middle  of  1920  it  was  admitted  by  bankers  that  the 
situation  was  better  in  hand  than  it  had  been  and 
that  the  post-war  speculative  era  had  been  at  least 
brought  toward  a  close.  It  was  an  imfortunate 
element  in  this  process  of  credit  control  that  some 
lines  of  business  in  which  there  had  been  overtrading 
and  inflation  were  obliged  to  suffer  more  or  less 
severely  through  the  price  readjustment  which  grew 
out  of  the  high  rates  for  money,  not  only  at  Federal 
Reserve  banks  but  in  the  investment  market.  This 
general  tendency  toward  disorganization  and  price 
revision  was  more  or  less  aggravated  by  the  fact  that 
lack  of  equipment  and  difficult  traffic  conditions  on 
the  railroads,  combined  with  labor  troubles,  had 
brought  about  a  serious  congestion  of  goods.  The 
work  of  the  Federal  Reserve  system  was  steadily 
directed  toward  assisting  in  the  carrying  and  main- 
tenance of  commercial  credit  accommodation  at  the 
same  time  that  it,  under  the  leadership  of  the  Federal 
Reserve  Board,  was  discouraging  the  growth  of 
speculative  loans. 

CLEARING  AND  COLLECTION 

One  of  the  provisions  of  the  Federal  Reserve  Act 
that  had  aroused  most  discussion  required  the  Fed- 
eral Reserve  banks  to  act  as  clearing  houses,  and 
to  receive  from  their  member  banks  checks  on  one 
another  and  on  outside  banks  for  collections.  There 
was  considerable  opposition  to  this  provision,  not 
only  during  the  time  the  Act  was  under  discussion, 
but  subsequently.  Nevertheless,  it  was  a  necessary 
element  in  the  proper  administration  of  the  law,  due 


THE  FEDERAL  RESERVE  SYSTEM  33 

to  the  fact  that  under  the  old  regime  the  balances 
carried  by  member  banks  with  their  correspondents 
in  the  cities  had  been  used  as  a  basis  for  collecting 
checks,  while  now  that  these  balances  were  to  be 
transferred  to  reserve  banks,  it  was  natural  and 
necessary  to  transfer  to  the  latter  the  duty  of  mak- 
ing the  collections,  using  the  reserve  balances  to 
protect  outstanding  checks  which  were  in  process 
of  such  collection. 

The  technical  Organization  Committee  had  recom- 
mended a  complete  plan  for  a  clearing  system  at  each 
Federal  reserve  bank,  as  well  as  for  a  clearing  plan 
between  Federal  reserve  banks.  The  latter  was  the 
first  taken  up. 

NATIONAL   GOLD  SETTLEMENT 

The  fundamental  conception  was  that  of  a  deposit 
of  gold  to  be  made  by  each  Federal  reserve  bank  with 
the  Federal  Reserve  Board,  the  actual  gold  being 
held  in  sub-treasuries  for  safekeeping,  while  the 
Board  itself  merely  held  possession  of  certificates 
representing  the  title  to  the  gold.  Each  Federal 
Reserve  bank  continued  to  carry  its  gold  in  the  Gold 
Settlement  Fund  as  a  part  of  its  reserves,  repre- 
senting it  in  this  way  on  its  books.  Then  from  week 
to  week  the  amount  of  the  items  due  to  other  Federal 
Reserve  banks  was  to  be  telegraphed  to  Washington 
and  there  offset  on  the  books  of  the  Gold  Settlement 
(clearing)  Fund.  The  result  would  be  to  bring  about 
a  general  cancellation  of  the  bulk  of  the  claims 
between  Federal  Reserve  banks. 

The  Gold  Settlement  Fimd,  as  thus  given  a  pre- 
liminary organization,  was  so  successful  and  satis- 


34        BLACKSTONE  LEGAL  TRAINING  LECTURE 

factory  in  its  working  that  on  July  1, 1918,  clearance 
was  ordered  to  be  made  by  telegram  on  a  daily  basis. 
The  daily  clearance  eliminated  many  technical  diffi- 
culties which  had  previously  existed  under  the  weekly 
settlement  system  and  brought  the  clearance  system 
in  its  national  aspects  very  close  to  perfection.  As 
has  already  been  noted  the  Federal  Reserve  system 
prior  to  the  entry  of  the  United  States  into  the  war 
was  still  in  a  formative  and  elementary  condition. 
With  the  arrival  of  a  necessity  for  making  enormous 
transfers  from  different  parts  of  the  country  growing 
out  of  the  immense  loans  placed  by  the  Government, 
securities  representing  which  were  distributed  all 
over  the  territory  of  the  United  States,  the  gold 
settlement  fund  took  on  an  importance  which  could 
hardly  be  overestimated.  Its  weekly  clearances 
assumed  vast  proportions  from  about  the  middle  of 
1917  onward.  Indeed,  had  it  not  been  for  the  exis- 
tence of  the  clearance  system  the  Government  with 
its  obsolete  sub-Treasury  method  of  collecting  the 
proceeds  of  public  loans  would  have  found  itself  in 
an  almost  impossible  position.  After  the  placing  of 
the  gold  clearance  system  upon  a  daily  basis,  the 
idea  of  clearance  in  this  way  attained  so  strong  a 
foothold  that  the  introduction  of  an  international 
gold  clearance  fund  as  an  element  in  the  plan  for  the 
League  of  Nations  was  advocated.  In  recent  months, 
average  transfers  made  through  the  gold  settlement 
fund  have  amounted  to  about  $300,000,000  per  day. 
There  was  thus  created  a  general  national  clear- 
ance system,  although  this  was  limited  in  its  scope 
by  the  extent  of  the  clearing  carried  on  in  the  several 
districts  under  the  intra-district  clearance  plan.    It 


THE  FEDERAL  RESERVE  SYSTEM  35 

will  be  observed  that  there  was  still  lacking  any  sys- 
tem for  inter-district  clearance — that  it  to  say,  no 
plan  had  been  devised  for  the  depositing  of  checks 
with  a  member  bank  if  they  had  been  drawn  upon 
member  banks  in  other  districts.  The  lack  of  such 
a  provision  prevented  checks  thus  drawn  upon  mem- 
ber banks  in  other  districts  from  going  through  the 
Federal  Reserve  banks  in  the  district  in  which  the 
recipient  of  such  checks  was  situated. 


LOCAL  CLEARING  SYSTEM 

In  order  to  make  the  system  effective  a  plan  was 
early  devised  by  the  Governors  of  Federal  Reserve 
banks  for  the  establishment  of  a  so-called  voluntary 
clearing  system  which  was  to  include  only  those 
banks  that  saw  fit  to  join.  Although  a  considerable 
number  of  member  banks  did  voluntarily  join  this 
system,  there  were  not  enough  to  make  it  very  effec- 
tive, nor  was  the  plan  under  which  it  was  conducted 
sufficiently  inclusive  to  insure  success.  Consequently 
the  Federal  Reserve  Board  itself  developed  and  put 
into  effect  at  the  opening  of  July,  1916,  a  more  gen- 
eral and  effective  plan  of  collection  which  has  been 
developed  from  time  to  time  and  which  is  now  in 
force.  It  has  laid  the  foundation  of  a  general,  nation- 
wide clearing  system. 

By  the  terms  of  this  plan  any  bank  which  chooses 
to  do  so  may  deposit  checks  upon  any  other  bank  and 
these  checks  will  be  collected  and  the  proceeds  placed 
to  the  credit  of  the  depositing  bank.  Such  collec- 
tions are  not  immediately  credited,  but  credit  is 
allowed  only  after  the  lapse  of  a  stated  time  which 
corresponds  to  the  period  which  experience  has 


86        BLACKSTONE  LEGAL  TRAINING  LECTURE 

shown  to  be  necessary  for  presentation  and  collect- 
ing the  proceeds  of  such  checks. 

Member  banks,  as  long  as  they  comply  with  the 
statutory  requirements,  may  continue  to  carry  ac- 
counts with  correspondent  banks  in  other  cities,  or 
indeed  with  any  banks  to  whom  they  may  send  items 
for  collection  and  from  whom  they  may  receive, 
for  similar  purposes,  checks  drawn  upon  themselves 
or  upon  other  banks.  They  are,  however,  required  to 
pay  without  deduction  checks  drawn  upon  them- 
selves and  presented  at  their  own  counters  for  pay- 
ment. Remittance  of  such  checks  by  the  Federal  re- 
serve bank  of  their  district  through  the  mail  is  con- 
strued as  presentation  at  their  own  counters  and  they 
must  settle  with  the  Federal  reserve  bank  for  such 
checks,  either  by  acceptable  checks  upon  other  banks, 
or  by  remittance  of  lawful  money  or  Federal  reserve 
notes  at  the  expense  of  the  Federal  reserve  bank. 
Checks  drawn  upon  a  member  bank  which  have  been 
received  by  the  Federal  reserve  bank  are  not  charged 
against  its  reserve  account  until  sufficient  time  has 
elapsed  for  the  checks  to  reach  the  member  bank  and 
for  returns  to  have  been  received  in  due  course  by  the 
Federal  reserve  bank. 

Checks  upon  about  28,000  national  banks,  State 
banks,  and  trust  companies  throughout  the  United 
States  are  collected  by  the  Federal  reserve  banks  at 
par,  and  it  is  thought  that  in  the  near  future  checks 
upon  practically  all  banks  throughout  the  United 
States  can  be  collected  at  par  by  Federal  reserve 
banks. 

Many  banks  had  found  it  necessary  in  years  prior 
to  1914  to  scatter  their  available  funds  by  maintain- 


THE  FEDERAL  RESERVE  SYSTEM  37 

ing  balances  with  a  number  of  correspondents  for 
exchange  purposes,  or  in  order  to  control  checks 
drawn  upon  themselves.  Banks  now,  however,  find 
it  expedient  to  concentrate  their  balances  more 
largely  and  to  close  many  of  the  accounts  which  they 
have  in  the  past  carried  with  other  banks.  A  system 
which  enables  them  to  send  all  of  their  checks  on 
other  banks  to  the  Federal  reserve  banks  for  ex- 
change purposes  or  as  an  offset  against  checks  on 
themselves  forwarded  by  the  Federal  reserve  bank, 
is,  therefore,  a  convenience.  The  release  of  funds 
heretofore  tied  up  in  accounts  carried  with  other 
banks  and  their  employment  at  higher  rates  of  in- 
terest in  commercial  loans,  offsets  to  a  great  degree 
the  loss  of  exchange  profits  which  was  long  looked 
upon  with  apprehension  by  some  of  the  banks.  To 
the  business  man  the  new  clearance  system  has  al- 
ready proved  an  important  economy,  largely  re- 
ducing the  charges  heretofore  made  him  for  check 
collection. 

THE  NEW  CURRENCY  ISSUE 

It  has  been  a  principal  cause  of  complaint  of  the 
existing  currency  situation  in  the  United  States  for 
many  years  past  that  our  medium  contained  no  ele- 
ment corresponding  to  what  is  known  as  the  **  elas- 
tic" bank-note  issue  of  other  countries.  There  have 
been  many  kinds  of  currency,  the  principal  kinds 
in  circulation  before  the  adoption  of  the  new  act 
being  as  follows: 

(1)  United  States  notes  or  greenbacks,  legal 
tender  in  payment  of  debts. 

(2)  Gold  certificates  representing  actual  gold 
coin  held  as  a  trust  fund  in  Washington. 


38       BLACKSTONE  LEGAL  TRAINING  LECTURE 

(3)  Silver  certificates  representing  silver  coin 
held  as  a  trust  fund  against  them  in  Washington. 

(4)  Currency  certificates  representing  United 
States  notes  held  as  a  trust  fund  in  Washington  or 
at  sub-treasuries  (issued  only  for  the  convenience 
of  banks  in  very  large  denominations). 

(5)  Gold  coin,  legal  tender  in  pajonent  of  debts. 

(6)  Silver  doUars,  legal  tender  in  payment  of 
debts. 

(7)  Silver  subsidiary  coin,  legal  tender  in  pay- 
ment of  debts  up  to  $5. 

(8)  Minor  coins  of  limited  legal  tender  quality; 
and  finally: 

(9)  National  bank  notes  issued  by  the  banks  and 
protected  by  Government  bonds  deposited  with  the 
Treasury  Department. 

It  is  easily  seen  that  of  all  these  classes  of  currency 
and  money  which  have  been  in  circulation  none  could 
be  increased  save  by  the  actual  bringing  of  metal  to 
the  mint  for  coinage,  with  the  exception  of  national 
bank  notes.  The  latter  could  be  enlarged  in  volume 
by  the  deposit  of  Government  bonds  with  the  Treas- 
ury Department,  and  the  placing  of  a  5  per  cent  re- 
demption fund  in  the  same  hands.  Even  in  the  latter 
case,  however,  it  is  clear  that  the  amount  of  national 
bank  notes  which  could  be  issued  was  limited  in  the 
aggregate  amount  by  the  total  volume  of  United 
States  bonds  in  existence,  and  was  still  further 
limited  by  the  fact  that  many  such  bonds  were  held 
and  used  to  protect  public  deposits,  while  still  others 
were  held  by  investors,  and  so  were  not  available 
for  circulation  purposes.  As  the  national  bank  cur- 
rency had  increased  in  amount  until  it  absorbed 
practically  aU  of  the  available  volume  of  bonds,  it 


THE  FEDERAL  RESERVE  SYSTEM  39 

has  been  apparent  at  certain  times  in  the  past  that 
a  great  demand  for  notes  could  not  be  satisfied  by 
the  taking  out  of  bank  currency. 

PLANS  PBEPABED  TO  OVERCOME  EXISTING  DEFECTS 

In  order  to  overcome  the  ** inelasticity"  of  prac- 
tically every  element  in  the  currency  system  various 
plans  have  been  proposed.  The  experience  of  othei* 
countries  and  the  theory  of  banking  have  both  com- 
bined to  indicate  that  there  is  no  sound  reason  for 
differentiating  between  the  protection  accorded  to 
notes  and  that  accorded  to  deposits;  but  that  what 
is  sufficient  in  one  case  should  be  sufficient  in  all 
others,  and  that  this  (as  the  experience  of  our  nation 
indicated)  should  be  the  best  constituent  of  the  assets 
of  the  banks — namely,  sound,  short-time  commercial 
paper.  The  difficulty  in  applying  this  standard  has 
been  twofold: 

(1)  It  has  been  contended  that  there  was  not  suf- 
ficient sound  paper  of  the  kind  required  in  the  United 
States,  and 

(2)  It  has  been  urged  that  existing  bank  notes 
could  not  be  displaced  on  account  of  the  injustice  to 
the  banks  which  had  bought  bonds  to  deposit  as 
security  for  the  notes,  and  for  other  reasons. 

The  problem,  therefore,  of  those  who  wished  to 
introduce  a  more  satisfactory  method  of  issuing  new 
currency  was  that  of  protecting  the  owners  of 
existing  bonds  and  at  the  same  time  of  furnishing 
an  adequate  basis  of  imdoubtedly  sound  commercial 
paper  deposited  to  protect  the  issue  of  new  notes.  To 
attain  these  objects  there  have  been  offered  many 
complex  plans  in  the  past,  and  an  additional  element 


40       BLACKSTONE  LEGAL  TRAINING  LECTURE 

of  complexity  has  been  added  by  reason  of  the  at- 
tempt usually  made  to  introduce  special  means  of 
insuring  the  safety  and  goodness  of  the  notes. 


PROVISIONS  IN  THE  ACT  CONCERNING 
NOTE  CURRENCY 

When  the  Federal  Reserve  Act  was  in  process  of 
drafting,  all  these  considerations  were  taken  imder 
advisement,  and  it  was  sought  both  to  provide  for  the 
proper  treatment  of  existing  note  currency  as  well  as 
for  the  issue  of  new  notes.  Originally  the  Federal 
Reserve  Act  provided  for  the  refimding  of  existing 
bonds,  that  is  to  say,  the  exchange  of  the  bonds  now 
outstanding  for  new  bonds  to  bear  3  per  cent  in- 
terest, and  the  gradual  retirement  of  national  bank 
currency  as  this  refunding  proceeded.  Provision 
was  also  made  for  the  issue  of  bank  notes  by  the 
several  reserve  banks,  based  upon  the  deposit  of  com- 
mercial paper  of  the  kind  made  eligible  for  re- 
discount under  the  terms  of  the  law;  and  the  general 
purpose  contemplated  by  the  measure  was  that  in  the 
course  of  twenty  years  the  existing  national  bank 
notes  should  be  retired,  and  the  new  Federal  reserve 
notes  should  take  their  place. 

While  the  Act  was  under  consideration  in  Congress 
alterations  were  introduced  into  it,  and  the  ma- 
chinery by  which  the  purposes  of  the  Act  were  to 
be  fulfilled  was  altered,  although  it  may  be  broadly 
said  there  was  no  change  in  the  objects  ultimately 
aimed  at.  Probably  the  most  important  alteration 
thus  made  in  the  terms  of  the  law  was  that  which 
designated  the  new  Federal  reserve  notes  as  obli- 
gations of  the  United  States,  thus  making  them,  in 


THE  FEDERAL  RESERVE  SYSTEM    ■  41 

the  technical  sense,  at  least,  a  Government  currency. 
Another  important  innovation  was  a  provision 
whereby  Federal  reserve  banks  might  be  required 
by  the  Federal  Reserve  Board  to  buy  national  2  per 
cent  bonds  held  by  member  banks  at  a  rate  not  to 
exceed  $25,000,000  per  anmun,  while  they  were  to 
be  permitted  to  issue  a  new  kind  of  currency  to  be 
known  as  Federal  reserve  bank  notes  on  the  strength 
of  the  bonds  which  they  thus  acquired.  The  Act, 
therefore,  provided  for  two  new  classes  of  currency: 

(1)  Federal  reserve  notes,  and 

(2)  Federal  reserve  bank  notes, 

the  former  protected  by  commercial  paper  of  the 
kind  rendered  eligible  for  rediscount  imder  the  terms 
of  the  law,  the  latter  protected  by  national  2  per  cent 
bonds  purchased  from  the  member  banks  of  the  sys- 
tem, or  any  other  Government  bonds  owned  by  the 
national  reserve  banks  having  circulation  privileges. 
The  ultimate  form  of  the  Federal  Reserve  Act,  how- 
ever, provided  for  the  conversion  of  2  per  cent  bonds 
into  3  per  cent  bonds  by  Federal  reserve  banks,  such 
3  per  cent  bonds,  moreover,  to  lose  their  privilege 
of  deposit  to  protect  circulation. 

It  will  thus  be  seen  that,  under  the  terms  of  the 
Federal  Reserve  Act,  the  natural  development  would 
be  substitution  (at  the  end  of  a  period  of  years)  of 
Federal  reserve  notes  or  Federal  reserve  bank  notes 
for  national  bank  notes  with  accompanying  retire- 
ments of  these  latter  notes,  through  the  conversion 
of  the  2  per  cent  bonds  protecting  them,  into  3  per 
cent  bonds;  while,  in  the  meantime,  Federal  reserve 
notes  based  on  commercial  paper  would  be  issued 
from  time  to  time  as  demanded,  in  quantities  suffi- 
cient to  supply  the  elastic  element  in  currency,  and 


42        BLACKSTONE  LEGAL  TRAINING  LECTURE 

to  fill  up  such  gaps  in  existing  national  bank  notes  as 
might  be  caused  through  the  retirement  of  note 
issues  due  to  the  conversion  of  2  per  cent  into  3  per 
cent  bonds  not  bearing  the  circulation  privilege. 


PRACTICAL  EFFECT  UPON  CURRENCY 

It  is  now  time  to  see  how  this  technical  proceeding 
works  in  practice,  and  what  has  been  the  effect  of  it 
upon  the  average  man  the  country  over.  Let  us  first 
observe  with  some  care  exactly  what  gives  rise  to  a 
demand  for  currency  and  to  consequent  issues  of 
Federal  reserve  notes.  When  A  trades  with  B  to  the 
extent  of  $100,000  worth  of  goods  he  thereby  creates 
a  demand  for  some  means  of  transferring  the  value 
of  $100,000.  This  exchange  may  be  made  by  the 
actual  use  of  money,  or  by  the  drawing  of  a  check. 

Where  the  buyer  of  the  goods  does  not  have  the 
means  to  pay  for  them  he  usually  applies  to  his  bank 
for  accommodation,  and  such  bank  may  meet  his 
requirements  by  giving  him  a  credit  on  its  books 
technically  known  as  a  ** deposit,"  or  by  issuing  to 
him  its  own  note  or  the  equivalent  thereof.  There  is 
no  reason  why  the  bank  which  is  thus  applied  to,  if  it 
desires  to  grant  the  credit  at  all,  should  not  give  the 
accommodation  in  either  form  that  may  be  desired  by 
the  customer.  The  customer  is  likely  to  be  governed 
entirely  by  the  demand  of  the  people  with  whom  he 
is  dealing  as  to  the  form  of  payment  required.  In 
the  case  of  the  bill  of  goods  for  $100,000  already 
spoken  of,  it  is  probable  that  a  check  on  the  bank 
would  be  exactly  what  he  wanted,  in  which  case  no 
question  of  note  issue  is  raised.  But  it  may  also  be 
that  the  funds  are  not  wanted  for  a  siagle  payment 


THE  FEDERAL  RESERVE  SYSTEM  43 

of  this  kind,  but  that  accommodation  is  sought  for 
some  purpose  which  necessitates  a  number  of  small 
payments  to  persons  who  do  not  or  cannot  employ 
bank  checks.  In  this  instance  notes  would  be  needed. 
Or  it  may  happen  that  a  bank  discounts  some  paper 
for  the  purpose  of  getting  notes  with  which  to  supply 
actual  calls  for  currency  made  by  its  customers  who 
are  not  necessarily  borrowers  but  who  want  notes  to 
carry  in  their  pockets  for  the  purpose  of  meeting 
demands  from  day  to  day. 

What  the  Federal  Reserve  Act  does  is  to  permit 
a  bank  to  take  the  promises  of  individuals  to  pay  at 
the  end  of  a  designated  period,  indorse  these  prom- 
ises with  its  own  signature,  and,  by  the  deposit  of 
them  with  the  Federal  reserve  bank,  obtain  in  ex- 
change Federal  reserve  notes  issued  to  that  bank  by 
a  Government  officer  known  as  a  Federal  Reserve 
Agent.  The  fact  that  these  notes  are  technically 
obligations  of  the  Government  confuses  the  situation 
to  some  extent,  because  it  makes  the  transaction  ap- 
pear as  if  it  were  one  which  involved  the  Govern- 
ment in  some  way.  As  a  matter  of  fact,  it  is  the 
member  bank's  demand  which  gives  the  signal  for 
the  issue  of  the  notes  and  determines  how  many  of 
them  shall  come  out;  while  it  is  the  demand  of  the 
customer  of  the  member  bank  which  influences  the 
action  of  that  bank  in  applying  for  them. 

Ultimately  and  in  broadest  terms,  then,  the  pro- 
vision of  the  Federal  Reserve  Act  simply  allows  in- 
dividuals to  make  their  own  obligations,  based  on 
commercial,  industrial,  or  agricultural  transactions, 
and  then,  by  putting  these  through  a  local  bank,  to 
get  note  currency  corresponding  thereto.  As  long  as 
their  credit  is  good  they  can  get  the  notes,  provided 


44        BLACKSTONE  LEGAL  TRAINING  LECTURE 

that  the  Federal  reserve  bank  is  in  a  position  to 
protect  these  notes  amply  with  gold.  Under  the 
terms  of  the  Federal  Reserve  Act  this  protection 
must  amount  to  at  least  40  per  cent  of  the  face  of  the 
note  issue;  and  of  this  40  per  cent  five  per  cent  is 
deposited  with  the  Treasury  Department  for  cur- 
rent redemption,  the  other  35  per  cent  being  held  in 
the  vaults  of  the  Federal  reserve  bank  which  issues 
the  notes. 

A  change  introduced  into  the  terms  of  the  cur- 
rency section  of  the  act  in  1917  has  always 
been  open  to  serious  question  and  criticism.  By  the 
terms  of  that  amendment  it  was  provided  that  the 
40  per  cent  gold  reserve  held  by  a  Federal  Reserve 
bank  against  notes  is  to  be  counted  as  part  of  the 
protection  maintained  by  the  bank  against  its  out- 
standing circulation.  The  effect  of  this  amendment 
was  that  whereas  under  the  original  Federal  reserve 
act  there  was  always  100  per  cent  of  commercial 
paper  and  40  per  cent  gold  behind  note  issues,  the 
new  plan  would  permit  the  combined  amount  of  gold 
and  commercial  paper  to  fall  to  100  per  cent  of  the 
outstanding  notes.  The  currency  is  fairly  elastic,  in- 
asmuch as  it  can  be  increased  to  the  extent  of  two 
and  one-half  times  the  supply  of  gold  available — 
100  per  cent  being  two  and  one-half  times  40  per 
cent — while  it  is  safe,  inasmuch  as  the  protection  is 
adequate  to  all  ordinary  requirements.  Nothing 
limits  the  amount  of  notes  that  can  be  issued,  there- 
fore, except  the  needs  of  the  business  commimity 
and  the  adjustment  of  the  country's  gold  supply  to 
that  of  other  nations. 


THE  FEDERAL  RESERVE  SYSTEM       45 

THE  EFFECT  OF  THE  WAR  ON  CURRENCY 

It  should  be  frankly  stated  that  the  theory  of  cur- 
rency issue  which  is  thus  set  forth  as  haviag  been 
embodied  in  the  Federal  Reserve  Act  has  not  effec- 
tively worked  out  in  practice.  From  what  has  been 
said  it  will  be  plain  that  the  essential  and  underlying 
idea  of  the  Federal  Reserve  Act  or  of  any  legislation 
based  upon  the  same  general  principle  is  that  of  us- 
ing commercial  paper  growing  out  of  live  business 
transactions  as  a  basis  for  currency.  Whenever  the 
paper  which  is  discounted  does  not  grow  out  of  busi- 
ness transactions  the  basis  upon  which  the  theory 
of  currency  issue  rests  is  changed.  As  has  been 
shown  at  an  earlier  point,  the  entry  of  the  United 
States  into  the  war  made  it  necessary  to  raise  very 
large  sums  of  money,  and  by  the  process  of  financing 
which  was  then  employed  these  sums  were  first  ob- 
tained through  the  issue  of  short-term  obligations, 
which  were  made  available  as  a  basis  for  rediscount 
at  Federal  Reserve  banks,  and  which  were  held  by 
members  banks,  later,  by  the  issue  of  bonds  which 
could  be  coUateraled  in  the  same  way.  Thus  the 
paper  held  by  Federal  reserve  banks  came  to  consist 
in  no  small  degree  of  notes  coUateraled  by  Govern- 
ment bonds.  Many  of  these  loans  were  made  merely 
for  the  purpose  of  enabling  subscribers  to  buy  and 
pay  for  Government  bonds;  others  were  made  for 
purely  speculative  purposes.  Neither  kind  of  paper 
represented  live  transactions  or  provided  a  means 
whereby  liquidation  could  be  assured  at  maturity. 
The  result  was  to  destroy  in  large  measure  the  effec- 
tiveness of  the  provisions  contained  in  the  law  for  the 
maintenance  of  elasticity  in  the  currency,  as  the 


46        BLACKSTONE  LEGAL  TRAINING  LECTURE 

currency  increased  and  as  deposit  credits  were 
granted  upon  the  books  of  Reserve  banks  through 
the  rediscounting  of  notes  collateraled  by  Govern- 
ment obligations,  since  there  was  built  up  a  large 
structure  of  available  funds  which  were  not  based 
upon  commodities  currently  produced,  but  were 
based  upon  investment  securities.  This  brought 
about  what  is  known  as  inflation  and  along  with  a 
relative  shortage  of  production  as  compared  with 
demand,  tended  to  raise  prices  very  materially. 

By  the  middle  of  the  year  1920  the  index  number 
of  prices,  taking  the  year  1913  as  a  100  per  cent 
base,  had  risen  to  273,  and  while  this  advance  was 
by  no  means  entirely  due  to  banking  causes,  the  in- 
flation to  which  reference  has  been  made  no  doubt 
contributed  in  an  important  way  to  the  general  re- 
sult. During  these  years  the  currency  issue  of  the 
Federal  reserve  banks  rose  from  a  merely  nominal 
figure  shortly  after  organization  to  about  $3,100,- 
000,000  at  the  middle  of  1920,  although  a  part  of 
this  growth  represented  a  substitution  of  reserve 
notes  for  gold  certificates  which  had  been  accumu- 
lated in  banks.  The  later  months  of  1920  have  seen 
a  sharp  fall  in  prices  reflected  in  a  decided  decline 
of  the  index  number,  and  aided  by  the  gradual 
elimination  of  long  term  and  speculative  paper 
from  the  banks.  Both  inflation  and  deflation  were 
painful  processes,  though  the  later  was  a  necessary 
consequence  of  the  former. 

While  Federal  Reserve  notes  had  been  active  in 
their  movement  into  and  out  of  the  banks,  thus  show- 
ing a  good  redemptive  power,  they  had  not  been 
elastic  in  the  sense  that  they  expanded  and  con- 
tracted freely  as  business  fell  and  rose  —  in  other 


THE  FEDERAL  RESERVE  SYSTEM  47 

words,  they  have  not  shown  that  close  dependence 
upon  and  correspondence  to  the  volume  of  business 
transactions  which  is  the  mark  of  an  elastic  currency. 
The  reason  is  that  the  basis  for  credit  at  Federal 
Reserve  banks  has  not  been  a  pure  type  of  business 
paper  as  had  been  expected  to  be  the  case. 

FINANCING  FOREIGN  TRADE 

One  of  the  innovations  provided  by  the  Federal 
Reserve  Act  is  found  in  the  section  relating  to  for- 
eign branches.  It  has  been  a  subject  of  complaint 
for  a  long  time  that  the  foreign  trade  of  the  United 
States  was  inadequately  financed.  National  banks 
not  being  permitted  under  existing  law  to  establish 
branches  abroad,  it  has  been  felt  that  in  many  cases 
Americans  doing  a  foreign  business  could  not  get  the 
accommodation  to  which  they  were  entitled.  It  has 
been  asserted  that  in  those  countries  where  the  for- 
eign trade  of  the  United  States  was  still  limited  in 
amount  and  undergoing  development  subject  to  more 
or  less  severe  competition,  the  problem  of  securing 
adequate  funds  for  the  trade  was  particularly 
difficult. 

This  state  of  affairs  was  fully  recognized  through- 
out the  later  years  of  the  agitation  for  new  banking 
legislation.  In  the  National  Monetary  Commission's 
investigation  and  report  much  attention  was  given  to 
international  relationships,  and  the  report  dwelt  ex- 
tensively upon  the  need  of  a  better  method  of  financ- 
ing the  exports  of  the  United  States  and  the  foreign 
trade  of  the  nation  in  general. 

When  the  Federal  Reserve  Act  was  imder  consid- 
eration, it  was  at  first  thought  that  the  plan  of  joint 


48        BLACKSTONE  LEGAL  TRAINING  LECTURE 

association  of  banks  for  the  establishment  of 
branches  would  be  the  more  desirable  provision,  but 
subsequently  this  view  was  abandoned;  and  in  the 
final  Act  provision  was  made  for  permitting  any  na- 
tional bank  having  a  capital  and  surplus  of  not  less 
than  $1,000,000,  to  establish  foreign  branches.  It 
was  left  to  the  Federal  Reserve  Board  to  determine 
by  regulation  about  how  much  capital  should  be 
allotted  to  such  branches,  and  what  should  be  the 
conditions  surrounding  their  establishment.  Owing 
to  the  demand  of  business  organizations,  however, 
the  Act  was  further  amended  on  September  7,  1916, 
by  providing  that  national  banks  might  join  to- 
gether for  the  purpose  of  organizing  other  banks  to 
engage  in  foreign  operations  under  carefully 
guarded  condition.  A  few  such  banks  have  been 
organized  but  the  movement  has  not  gone  far. 

The  Federal  Reserve  Act,  however,  approached  the 
question  of  financing  foreign  trade  not  only  from  the 
standpoint  of  the  machinery  involved,  but  also  from 
that  of  practical  business  methods.  It  is  well  known 
that  foreign  business  generally  is  transacted  upon 
the  basis  of  standard  paper  known  as  *' acceptances." 
The  National  Bank  Act,  however,  never  legalized  the 
use  of  acceptances,  and  they  had,  therefore,  been  re- 
garded as  a  prohibited  type  of  paper.  The  result  is 
that  they  had  not  figured  to  any  great  extent  in 
American  banking  practice.  There  was  nothing  to 
prevent  State  banking  laws  from  providing  for  the 
use  of  acceptances,  but  such  laws  have  usually  been 
modeled  upon  the  National  Bank  Act,  and  had,  there- 
fore, been  accustomed  either  to  ignore  the  acceptance 
question  or  to  prohibit  this  form  of  paper.  The 
Federal  Reserve  Act  provided  that  any  national  bank 


THE  FEDERAL  RESERVE  SYSTEM  49 

might  accept  paper  growing  out  of  actual  commer- 
cial transactions  involving  the  importation  or  ex- 
portation of  goods,  and  having  not  more  than  six 
months  to  run;  while  it  also  authorized  Federal  Re- 
serve banks  to  rediscount  such  acceptances  when  in- 
dorsed by  member  banks,  or  to  buy  them  in  open 
market  whether  with  or  without  the  indorsement  of 
member  banks. 

How  this  provision  bears  especially  upon  financing 
our  foreign  trade,  and  what  are  its  important  indi- 
rect effects  upon  banking  and  commercial  operations 
generally,  may  be  imderstood  by  reference  to  prevail- 
ing methods  of  financing  foreign  trade.  In  trade 
between  foreign  countries  the  method  of  procedure 
is  somewhat  as  follows:  A  merchant.  A,  in  Buenos 
Ayres,  ships  coffee  to  B  in  Liverpool.  It  is  agreed 
that  B  will  accept  the  draft  accompanying  the  coffee 
at  ninety  days  sight.  It  may  be,  however,  that  A, 
when  shipping  the  coffee,  desires  to  arrange  for  a 
credit  that  would  enable  him  to  liquidate  very 
promptly.  He  may,  therefore,  have  agreed  with  B 
that  his  draft  for  the  coffee  shall  be  accepted  by  a 
Liverpool  bank.  This  bank  is  induced  by  B  to  agree 
to  accept  the  draft  when  it  is  presented.  B  may  pro- 
tect the  bank  in  some  special  manner  if  the  institu- 
tion demands  such  action,  or  he  may  simply  have 
made  a  satisfactory  statement  and  showing  to  the 
bank  so  that  that  institution  is  willing  to  accept  the 
draft  in  consideration  of  a  moderate  commission  or 
discount  paid  it  by  B  for  the  service.  When  it 
has  thus  accepted  the  draft — that  is,  agreed  to  pay 
it  at  maturity, — the  paper  becomes  the  obligation  of 
a  bank  of  known  standing,  and  is,  therefore,  readily 
salable  to  some  other  bank.    The  discount  on  it  will 


50        BLACKSTONE  LEGAL  TRAINING  LECTURE 

consequently  be  low,  and  the  original  drawer  of  the 
draft  will  be  able  to  get  his  money  immediately  with 
little  sacrifice.  This  means  that  he  can  sell  very 
much  more  closely  than  would  otherwise  be  possible, 
because  he  knows  that  he  will  lose  very  little  money 
in  the  form  of  discount  or  interest. 

WAE  AND  TEADE  FINANCE 

As  in  the  case  of  other  phases  of  our  banking  de- 
velopment, the  financing  of  our  foreign  trade  has 
been  influenced  in  a  very  important  way  by  the  war. 
It  first  had  seemed  probable  that  the  war  would  give 
us  an  important  leadership.  After  we  entered  the 
struggle  the  financing  of  goods  going  abroad  was, 
However,  largely  taken  over  by  our  Government  by 
reason  of  the  fact  that  it  extended  great  credits  to  for- 
eign countries  which  used  them  in  paying  our  export- 
ers. After  the  close  of  the  war  and  the  withdrawal  of 
the  Government  from  this  phase  of  its  financial  co- 
operation with  the  Allies,  there  was  a  period  of  un- 
certainty during  which  American  banks  were  en- 
deavoring to  get  back  into  the  field  of  foreign  trade 
financing. 

The  year  1919  and  the  beginning  of  the  year  1920 
were  a  period  of  reaction  during  which  the  extremely 
favorable  conditions  which  had  worked  in  behalf  of 
the  development  of  New  York  as  an  international 
market  were  largely  reversed  or  neutralized.  British 
banks  and  British  commercial  houses  naturally  took 
advantage  of  the  situation  to  get  back  as  much  of 
their  lost  foreign  trade  and  foreign  connections  as 
they  could.  One  result  thus,  was  that,  partly  in  con- 
sequence of  erroneous  policies  in  the  United  States, 


THE  FEDERAL  RESERVE  SYSTEM  51 

partly  owing  to  incidental  conditions  over  which 
Americans  had  no  control,  and  partly  as  a  result  of 
the  cumulative  effect  of  war  shortage  of  capital 
(which  had  been  masked  during  the  continuance  of 
the  conflict  and  suddenly  allowed  to  appear  upon  its 
close,)  the  retrogression,  during  the  sixteen  months 
since  the  armistice,  in  American  banking  participa- 
tion in  foreign  finance  and  business  was  much 
greater  than  it  would  normally,  or  perhaps  ought 
to,  have  been. 

How  serious  such  retrogression  has  been  in  some 
instances  may  be  illustrated  by  the  case  of  one 
of  the  leading  financial  institutions  of  New  York 
which  during  the  year  1919  was  said  to  have  lost 
about  two-thirds  of  its  entire  foreign  bank  deposits. 
The  real  character  of  the  problem  was  also  seen  from 
a  study  of  the  bankers'  acceptance  situation.  Where- 
as during  the  year  1919  there  was  a  continuous  in- 
crease in  the  volume  of  bankers'  acceptances  created, 
the  acceptance  being  widely  used  for  the  purpose  of 
financing  the  great  foreign  trade  of  the  United  States 
so  that  acceptance  liabilities  of  the  New  York  dis- 
trict which  were  estimated  at  about  $275,000,000 
since  September  1, 1918,  were  about  $335,000,000  on 
December  31, 1919,  the  distribution  of  this  increased 
volume  of  bills  became  more  and  more  difficult.  Not 
only  did  discount  houses  and  dealers  in  bills  have  to 
carry  larger  ^'portfolios"  often  requiring  for  that 
purpose  funds  obtainable  only  at  rates  equal  to  or 
higher  than  those  earned  by  their  portfolios,  but 
Federal  Reserve  banks  found  it  necessary  to  absorb 
an  increasing  amount  of  bills  in  the  open  market, 
while  advancing  their  rates  during  the  year  from 
4%  per  cent  to  5  per  cent  on  90-day  paper. 


52        BLACKSTONB  LEGAL  TRAINING  LECTURE 

The  natural  consequence  of  this  situation  was  to 
drive  a  great  deal  of  financing  abroad  which  would 
otherwise  have  remained  in  the  United  States,  and 
the  prevalence  of  such  conditions  for  a  long  period  of 
time  necessarily  would  make  probable  further  such 
transfers  of  financing. 

To  sum  up  the  whole  situation — ^American  banking 
institutions  have  made  only  a  relatively  small  degree 
of  progress  abroad.  What  they  have  done  they  have 
done  in  such  a  way  as  to  avoid  so  far  as  possible  com- 
petition with  the  banking  systems  of  the  other 
nations.  Federal  Reserve  banks  have  likewise  been 
very  cautious  about  incurring  losses  due  to  pur- 
chases of  exchange,  while  they  have  also  sought  to 
steer  clear  of  undue  competition  with  foreigners.  The 
disturbed  conditions  succeeding  the  armistice  have 
worked  very  greatly  against  the  general  develop- 
ment of  international  finance  which  the  American 
banking  system  had  unconsciously,  and  in  a  sense 
involuntarily,  taken  upon  itself  during  the  war. 
Groimd  is  being  lost  in  international  financial  rela- 
tionships and  the  question  of  how  far  a  recovery  will 
be  possible  depends  upon  a  variety  of  large  factors, 
such  as  the  policy  of  the  Federal  Reserve  system,  the 
degree  of  success  in  the  establishment  of  a  discount 
market,  and  others  of  the  same  sort.  The  future  of 
American  banking  in  the  foreign  field  is  certainly 
beyond  the  power  of  prediction  at  the  present  time. 

RELATION  TO  GOVERNMENT 

One  of  the  features  of  the  Federal  Reserve  Act 
which  has  already  proven  of  greatest  importance  is 
found  in  its  relation  to  the  Government.    Ever  since 


THE  FEDERAL  RESERVE  SYSTEM  53 

the  passage  of  the  Independent  Treasury  Act  in  1846 
there  had  been  an  effort  on  the  part  of  the  Govern- 
ment to  keep  as  much  of  its  funds  as  possible  in  sub- 
treasuries.  The  plan  was  unsuccessful  because  when 
large  surpluses  accumulated  they  were  withdrawn 
from  actual  commercial  use,  and  caused  a  corre- 
sponding shrinkage  of  bank  reserves,  while  if  the 
Treasury  redeposited  these  funds  with  national 
banks  the  distribution  was  not  always  wisely  made. 
The  Federal  Reserve  Act,  in  view  of  these  con- 
siderations, endeavored  to  effect  two  distinct  changes 
in  the  existing  relations  between  the  Government 
and  the  reserve  institutions : 

(1)  It  provided  for  the  depositing  of  Government 
fimds  in  Federal  Reserve  banks,  which  were  author- 
ized to  act  as  *' fiscal  agents,"  and 

(2)  It  authorized  Federal  Reserve  banks  to  deal 
in  Government  securities. 

These  provisions  enabled  the  Government  to  be- 
come a  depositor  at  Federal  reserve  banks  in  com- 
mon with  the  various  member  banks  of  the  country, 
and,  through  the  permission  of  the  reserve  banks  to 
trade  in  Government  securities  (while  acting  as  fiscal 
agents),  practically  enabled  the  Government  to  resort 
to  the  banks  for  accommodation  should  it  desire  to 
do  so.  In  one  very  special  way  an  important  relation- 
ship is  established  between  the  Government  and  the 
Federal  Reserve  banks.  Provision  was  made,  as  has 
been  seen,  in  connection  with  our  treatment  of  the 
currency  question,  for  the  gradual  transfer,  at  a  rate 
not  exceeding  $25,000,000  per  annum,  of  the  national 
bonds  now  held  by  the  national  banks  to  the  Federal 
Reserve  banks.  The  reason  for  introducing  this  pro- 
vision is  found  in  the  fact  that  in  order  to  bring  about 


54        BLACKSTONE  LEGAL  TRAINING  LECTURE 

an  improved  currency  situation  it  was  necessary  to 
deprive  the  national  banks  of  their  exclusive  power 
of  issuing  notes  based  on  Government  bonds.  This,  of 
course,  meant  that  in  all  equity  the  banks  must,  at 
some  reasonable  time,  be  relieved  of  their  bonds  at 
a  fair  figure.  The  Federal  Reserve  banks,  by  taking 
over  these  bonds,  were  gradually  to  mass  the  securi- 
ties in  their  own  hands,  and  consequently  relieve 
their  individual  members  who  have  disposed  of  their 
securities.  Ultimately,  it  was  assumed,  the  bonds 
would  be  refunded,  or  otherwise  provided  for  by  the 
Government  of  the  United  States  upon  some  satis- 
factory basis. 

At  the  beginning  of  the  year  1916  the  Secretary 
of  the  Treasury  designated  the  several  Federal  Re- 
serve banks  as  depositories,  transferring  to  them  the 
funds  of  the  Government  previously  located  in 
national  banks  in  the  twelve  Federal  reserve  cities, 
although  he  retained  the  funds  located  elsewhere  in 
national  banks,  just  as  before.  The  effect  was  to  give 
to  the  Federal  Reserve  banks  an  aggregate  deposit 
of  about  $30,000,000  at  times,  while  they  were,  on  the 
other  hand,  called  upon  to  conduct  an  active  check- 
ing business  for  the  Government.  The  process  of 
converting  the  2  per  cent  bonds  into  3  per  cent  bonds 
proceeded  steadily  through  the  intermediation  of  the 
Federal  Reserve  banks  until  the  entry  of  the  United 
States  into  the  war,  $30,000,000  having  been  so  con- 
verted during  the  year  1916,  while  the  Treasury 
announced  its  willingness  to  convert  a  Hke  sum  dur- 
ing 1917.  But  with  the  opening  of  the  war  condi- 
tions entirely  changed. 

A  description  has  already  been  given  of  the  great 
service  performed  by    Federal    Reserve  banks  as 


THE  FEDERAL  RESERVE  SYSTEM  55 

sellers  of  Government  obligations  and  as  discounters 
of  paper  secured  by  these  obligations  during  the  war, 
and  hence  need  not  be  recapitulated  at  this  point.  It 
is  only  necessary  to  say  here  that  the  war  left  the 
Federal  Reserve  system  as  practically  the  recognized 
fiscal  agent  of  the  Government  and  that  this  service 
has  been  continued  in  the  handling  of  short-term 
certificates  of  indebtedness  up  to  the  present  time. 
Congress,  moreover,  at  the  session  of  1919-1920  voted 
to  abolish  the  sub-Treasury  system,  an  action  which 
transferred  important  trust  and  routine  functions  to 
the  Federal  Reserve  banks.  From  this  time  forward, 
therefore,  the  relationship  between  the  Reserve 
banks  and  the  Government  will  necessarily  be  some- 
what that  which  exists  in  foreign  countries,  the 
banks  serving  as  the  active  agencies  of  the  Govern- 
ment in  the  conduct  of  its  ordinary  business  affairs. 

SERVICE  OF  FEDERAL  RESERVE  SYSTEM 

From  the  f  oregoiag  description  it  will  be  seen  what 
are  the  purposes  and  success  of  the  Federal  Reserve 
system  up  to  the  present  time.  It  is  essentially  a 
means  of  combining  the  resources  and  strength  of 
a  considerable  number  of  banks  for  the  purpose  of 
obtaining  the  benefits  of  united  action. 

A  review  of  the  detailed  provisions  of  the  measure 
shows  that,  while  the  conception  of  banking  reform 
upon  which  it  is  founded  is  the  same  that  has  con- 
stituted the  staple  of  the  bankiag  reform  movement 
of  recent  years,  and  while  the  conception  of  a  union 
of  banks  is  directly  borrowed,  as  in  other  bills  of  the 
years  1900-1910,  from  the  actual  practice  of  the  banks 
themselves  as  developed  under  the  stress  of  circum- 


56        BLACKSTONE  LEGAL  TRAINING  LECTURE 

stances  in  the  form  of  clearing-house  organizations; 
while,  moreover,  certain  phases  of  the  technique  of 
the  legislation  itself  followed  the  lines  of  the  Aldrich 
or  Monetary  Conunission  bill,  and  while  other  por- 
tions of  the  Act  have  been  adapted  from  well-known 
legislative  proposals  that  have  figured  within  the 
past  few  years  of  banking  discussion,  the  Act  as  a 
whole  is  based  upon  a  conception  and  plan  entirely 
its  own,  applies  in  many  fimdamental  respects  meth- 
ods of  control  and  administration  that  have  been 
given  at  least  a  new  form,  and  includes  several  impor- 
tant innovations,  not  heretofore  conspicuous  in  bank- 
ing discussion  although  admittedly  significant,  not  to 
say  necessary,  to  any  thorough  reorganization  upon 
sound  principles.  That  the  Act  also  contains  some 
elements  that  may  be  regarded  as  reminiscences  of 
the  less  desirable  and  more  objectionable  phases  of 
banking  agitation,  is  equally  certain.  These  are  seen, 
for  instance,  in  the  underlying  concept  of  the  Fed- 
eral reserve  notes,  which  are  thought  of  as  govern- 
ment currency  loaned  to  banks,  and  are  thus  at  least 
theoretically,  although  not  practically,  in  line  with 
so-called  '* government  currency"  schemes  of  past 
years.  Fundamentally,  the  system  is  based  upon  ex- 
perience and  upon  proved  workable  principles. 


■ 


y-faulora  — ^1 

GAYIAMOUNT® 
.PAMPHLET  BINDER 

.^__      Syracuse,  N.Y. 
,S=       Stockton.  Colif. 


UC  SOUTHERN  REGIONAL  LIBRARY  FACILITY 


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